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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: September 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
    
    85-0404134(State or other jurisdiction of
    
    (IRS Employerincorporation or organization)
    
    Identification Number)
 150 Washington AvenueSanta Fe, New Mexico
    
    87501(Address of principal executive offices)
    
    (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) 88,963,362 as of November 4, 2004




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INDEX  
 PagePART I. FINANCIAL INFORMATIONItem 1. Financial StatementsConsolidated Balance Sheets at September 30, 2004 and December 31, 2003
    
    
    3Consolidated Income Statements for the three and nine months ended
September 30, 2004 and September 30, 2003
    
    
    4Consolidated Statements of Comprehensive Income for the three and nine months
ended September 30, 2004 and September 30, 2003
    
    
    5Consolidated Statement of Shareholders Equity for the nine months
ended September 30, 2004 and September 30, 2003
    
    
    6Consolidated Statements of Cash Flows for the three and nine months ended
September 30, 2004 and September 30, 2003
    
    
    7Notes to Consolidated Financial Statements
    
    
    8Item 2. Managements Discussion and Analysis of
Financial Condition and Results of Operations
    
    
    26Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    61Item 4. Controls and Procedures
    
    
    61PART II. OTHER INFORMATIONItem 1. Legal Proceedings
    
    
    61Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    61Item 3. Defaults Upon Senior Securities
    
    
    61Item 4. Submission of Matters to a Vote of Security Holders
    
    
    61Item 5. Other Information
    
    
    61Item 6. Exhibits
    
    
    61SIGNATURES
    
    
    62EXHIBIT INDEX
    
    
    63Certification of CEO Pursuant to Rule 13a-14(a) and 15d-14(a)Certification of President and COO Pursuant to Rule 13a-14(a) and 15d-14(a)Certification of Executive Vice President and CFO Pursuant to Rule 13a-14(a) and 15d-14(a)Certification of CEO Pursuant to Section 906Certification of President and COO Pursuant to Section 906Certification of Executive Vice President and CFO Pursuant to Section 906
  2




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PART I. FINANCIAL INFORMATION 
 Item 1. FINANCIAL STATEMENTS THORNBURG MORTGAGE, INC. AND SUBSIDIARIES 
 CONSOLIDATED BALANCE SHEETS (Unaudited)
 September 30, 2004
    
    December 31, 2003ASSETSAdjustable-rate mortgage (ARM) assets:ARM securities, net
    
    $
    16,637,942
    
    
    $
    11,520,741ARM loans:Securitized ARM loans, net
    
    
    3,078,327
    
    
    
    3,687,466ARM loans collateralizing debt obligations, net
    
    
    5,862,711
    
    
    
    3,146,961ARM loans held for securitization, net
    
    
    461,249
    
    
    
    496,998ARM loans
    
    
    9,402,287
    
    
    
    7,331,425ARM assets
    
    
    26,040,229
    
    
    
    18,852,166Cash and cash equivalents
    
    
    137,024
    
    
    
    85,366Restricted cash and cash equivalents
    
    
    47,870
    
    
    
    51,600Hedging instruments
    
    
    81,952
    
    
    
    40,356Accrued interest receivable
    
    
    105,153
    
    
    
    73,702Prepaid expenses and other
    
    
    33,500
    
    
    
    15,609$
    26,445,728
    
    
    $
    19,118,799LIABILITIESReverse repurchase agreements
    
    $
    15,093,315
    
    
    $
    13,926,858Asset-backed commercial paper
    
    
    3,184,489
    
    
    
    Collateralized debt obligations (CDOs)
    
    
    5,801,776
    
    
    
    3,114,047Whole loan financing facilities
    
    
    297,470
    
    
    
    369,343Hedging instruments
    
    
    79,545
    
    
    
    113,518Senior notes
    
    
    251,400
    
    
    
    251,080Accrued interest payable
    
    
    38,225
    
    
    
    26,114Dividends payable
    
    
    
    
    
    
    47,350Accrued expenses and other
    
    
    51,303
    
    
    
    31,38524,797,523
    
    
    
    17,879,695COMMITMENTS AND CONTINGENCIESSHAREHOLDERS EQUITYCommon stock: par value $.01 per share;
499,978 shares authorized,
87,124 and 73,985 shares issued
and outstanding, respectively
    
    
    871
    
    
    
    740Additional paid-in-capital
    
    
    1,737,894
    
    
    
    1,376,879Accumulated other comprehensive loss
    
    
    (155,881
    )
    
    
    (142,778
    )Retained earnings
    
    
    65,321
    
    
    
    4,2631,648,205
    
    
    
    1,239,104$
    26,445,728
    
    
    $
    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
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Interest income from ARM assets and
cash equivalents
    
    $
    240,051
    
    
    $
    151,166
    
    
    $
    653,351
    
    
    $
    411,259Interest expense on borrowed funds
    
    
    (168,098
    )
    
    
    (91,261
    )
    
    
    (437,626
    )
    
    
    (244,589
    )Net interest income
    
    
    71,953
    
    
    
    59,905
    
    
    
    215,725
    
    
    
    166,670Servicing income, net
    
    
    1,702
    
    
    
    424
    
    
    
    3,894
    
    
    
    1,365Gain on ARM assets and hedging
instruments, net
    
    
    4,907
    
    
    
    1,820
    
    
    
    7,555
    
    
    
    5,400Hedging expense
    
    
    (149
    )
    
    
    (145
    )
    
    
    (456
    )
    
    
    (542
    )Provision for credit losses
    
    
    (322
    )
    
    
    (970
    )
    
    
    (1,145
    )
    
    
    (1,976
    )Management fee
    
    
    (4,184
    )
    
    
    (3,068
    )
    
    
    (11,747
    )
    
    
    (8,239
    )Performance fee
    
    
    (8,517
    )
    
    
    (7,136
    )
    
    
    (25,331
    )
    
    
    (20,247
    )Long-term incentive awards
    
    
    (3,530
    )
    
    
    (2,299
    )
    
    
    (7,681
    )
    
    
    (7,043
    )Other operating expenses
    
    
    (3,831
    )
    
    
    (2,763
    )
    
    
    (11,523
    )
    
    
    (8,354
    )NET INCOME
    
    $
    58,029
    
    
    $
    45,768
    
    
    $
    169,291
    
    
    $
    127,034Net income
    
    $
    58,029
    
    
    $
    45,768
    
    
    $
    169,291
    
    
    $
    127,034Dividends on preferred stock
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (3,340
    )Net income available to common shareholders
    
    $
    58,029
    
    
    $
    45,768
    
    
    $
    169,291
    
    
    $
    123,694Basic earnings per share:Net income
    
    $
    0.69
    
    
    $
    0.69
    
    
    $
    2.09
    
    
    $
    2.04Average number of shares outstanding
    
    
    84,643
    
    
    
    66,092
    
    
    
    80,896
    
    
    
    60,572Diluted earnings per share:Net income
    
    $
    0.69
    
    
    $
    0.68
    
    
    $
    2.09
    
    
    $
    2.02Average number of shares outstanding
    
    
    84,643
    
    
    
    67,532
    
    
    
    80,896
    
    
    
    62,887Dividends declared per common share
    
    $
    0.67
    
    
    $
    0.63
    
    
    $
    1.98
    
    
    $
    1.85
 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
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Net income
    
    $
    58,029
    
    
    $
    45,768
    
    
    $
    169,291
    
    
    $
    127,034Other comprehensive income:Unrealized gains (losses) on securities:Net unrealized holdings gains (losses)
arising during the period
    
    
    91,681
    
    
    
    (84,105
    )
    
    
    (75,326
    )
    
    
    (68,638
    )Reclassification adjustment for net gains
included in income
    
    
    (7,701
    )
    
    
    (1,834
    )
    
    
    (10,564
    )
    
    
    (4,259
    )Net change in unrealized gains (losses) on securities
    
    
    83,980
    
    
    
    (85,939
    )
    
    
    (85,890
    )
    
    
    (72,897
    )Unrealized gains (losses) on hedging instruments:Net unrealized losses arising during the period
    
    
    (171,673
    )
    
    
    (12,250
    )
    
    
    (118,861
    )
    
    
    (133,345
    )Reclassification adjustment for net losses
included in income
    
    
    63,253
    
    
    
    40,857
    
    
    
    191,648
    
    
    
    107,048Net change in unrealized gains (losses) on hedging
instruments
    
    
    (108,420
    )
    
    
    28,607
    
    
    
    72,787
    
    
    
    (26,297
    )Other comprehensive income
    
    
    (24,440
    )
    
    
    (57,332
    )
    
    
    (13,103
    )
    
    
    (99,194
    )Total comprehensive income
    
    $
    33,589
    
    
    $
    (11,564
    )
    
    $
    156,188
    
    
    $
    27,840
 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
    
    hensive
    
    From Stock
    
    RetainedStock
    
    Stock
    
    Paid-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
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    127,034
    
    
    
    127,034Other comprehensive income (loss):Available-for-sale assets:Fair value adjustment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (72,897
    )
    
    
    
    
    
    
    
    
    
    
    (72,897
    )Hedging instruments:Fair value adjustment, net of
amortization
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (26,297
    )
    
    
    
    
    
    
    
    
    
    
    (26,297
    )Issuance of common stock
    
    
    
    
    
    
    148
    
    
    
    337,570
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    337,718Conversion of preferred stock to
common stock
    
    
    (65,805
    )
    
    
    28
    
    
    
    65,777
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Interest and principal payments on
notes receivable from stock sales
    
    
    
    
    
    
    
    
    
    
    205
    
    
    
    
    
    
    
    1,527
    
    
    
    
    
    
    
    1,732Dividends declared on preferred
stock  $1.21 per share
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (3,340
    )
    
    
    (3,340
    )Dividends declared on common
stock  $1.22 per share
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (76,717
    )
    
    
    (76,717
    )Balance, September 30, 2003
    
    $
    
    
    
    $
    704
    
    
    $
    1,282,481
    
    
    $
    (204,448
    )
    
    $
    (5,910
    )
    
    $
    47,448
    
    
    $
    1,120,275Balance, December 31, 2003
    
    $
    
    
    
    $
    740
    
    
    $
    1,376,879
    
    
    $
    (142,778
    )
    
    $
    
    
    
    $
    4,263
    
    
    $
    1,239,104Comprehensive income:Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    169,291
    
    
    
    169,291Other comprehensive income (loss):Available-for-sale assets:Fair value adjustment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (85,890
    )
    
    
    
    
    
    
    
    
    
    
    (85,890
    )Hedging instruments:Fair value adjustment, net of
amortization
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    72,787
    
    
    
    
    
    
    
    
    
    
    
    72,787Issuance of common stock
    
    
    
    
    
    
    131
    
    
    
    361,015
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    361,146Dividends declared on common
stock  $1.31 per share
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (108,233
    )
    
    
    (108,233
    )Balance, September 30, 2004
    
    $
    
    
    
    $
    871
    
    
    $
    1,737,894
    
    
    $
    (155,881
    )
    
    $
    
    
    
    $
    65,321
    
    
    $
    1,648,205
 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
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Operating Activities:Net income
    
    $
    58,029
    
    
    $
    45,768
    
    
    $
    169,291
    
    
    $
    127,034Adjustments to reconcile net income to net cash provided
by operating activities:Amortization
    
    
    16,506
    
    
    
    12,772
    
    
    
    43,939
    
    
    
    31,343Gain on ARM assets and hedging instruments, net
    
    
    (4,907
    )
    
    
    (1,820
    )
    
    
    (7,555
    )
    
    
    (5,400
    )Provision for credit losses
    
    
    322
    
    
    
    970
    
    
    
    1,145
    
    
    
    1,976Hedging expense
    
    
    149
    
    
    
    145
    
    
    
    456
    
    
    
    542Change in assets and liabilities:Accrued interest receivable
    
    
    (16,427
    )
    
    
    (3,938
    )
    
    
    (31,451
    )
    
    
    (16,724
    )Prepaid expenses and other
    
    
    (8,243
    )
    
    
    (2,393
    )
    
    
    (20,883
    )
    
    
    (2,050
    )Accrued interest payable
    
    
    11,160
    
    
    
    4,581
    
    
    
    12,111
    
    
    
    10,168Accrued expenses and other
    
    
    16,147
    
    
    
    848
    
    
    
    19,918
    
    
    
    22,194Net cash provided by operating activities
    
    
    72,736
    
    
    
    56,933
    
    
    
    186,971
    
    
    
    169,083Investing Activities:ARM securities:Purchases
    
    
    (4,309,186
    )
    
    
    (2,639,527
    )
    
    
    (10,668,379
    )
    
    
    (7,602,663
    )Proceeds on sales
    
    
    778,225
    
    
    
    
    
    
    
    1,126,934
    
    
    
    Principal payments
    
    
    1,223,300
    
    
    
    1,808,092
    
    
    
    4,307,324
    
    
    
    3,780,319Securitized ARM loans:Principal payments
    
    
    147,786
    
    
    
    392,664
    
    
    
    472,625
    
    
    
    1,024,375ARM loans collateralizing debt obligations:Principal payments
    
    
    278,571
    
    
    
    165,175
    
    
    
    715,618
    
    
    
    256,557ARM loans held for securitization:Purchases and originations
    
    
    (1,176,445
    )
    
    
    (1,607,494
    )
    
    
    (3,304,144
    )
    
    
    (3,958,210
    )Principal payments
    
    
    16,357
    
    
    
    20,920
    
    
    
    44,784
    
    
    
    37,006Termination of interest rate swap agreements
    
    
    
    
    
    
    
    
    
    
    2,144
    
    
    
    Net cash used in investing activities
    
    
    (3,041,392
    )
    
    
    (1,860,170
    )
    
    
    (7,303,094
    )
    
    
    (6,462,616
    )Financing Activities:Net reverse repurchase agreements (paydowns) borrowings
    
    
    (2,249,103
    )
    
    
    493,752
    
    
    
    1,166,457
    
    
    
    4,153,303Net borrowings from asset-backed commercial paper
    
    
    3,184,489
    
    
    
    
    
    
    
    3,184,489
    
    
    
    Net borrowings of CDOs
    
    
    978,425
    
    
    
    1,185,324
    
    
    
    2,687,729
    
    
    
    1,897,394Net whole loan financing facilities borrowings (paydowns)
    
    
    2,707
    
    
    
    406,711
    
    
    
    (71,873
    )
    
    
    432,133Net senior unsecured debt proceeds
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    194,340Payments on Eurodollar contracts
    
    
    (2,197
    )
    
    
    (3,620
    )
    
    
    (3,420
    )
    
    
    (16,175
    )Proceeds from common stock issued, net
    
    
    114,185
    
    
    
    159,064
    
    
    
    361,146
    
    
    
    337,718Dividends paid
    
    
    (55,496
    )
    
    
    (42,644
    )
    
    
    (155,583
    )
    
    
    (112,591
    )Payments on notes receivable from stock sales
    
    
    
    
    
    
    1,171
    
    
    
    
    
    
    
    1,732Purchase of interest rate cap agreements
    
    
    
    
    
    
    (20,197
    )
    
    
    (4,894
    )
    
    
    (29,137
    )Net increase (decrease) in restricted cash and cash equivalents
    
    
    256,832
    
    
    
    (221,626
    )
    
    
    3,730
    
    
    
    (434,057
    )Net cash provided by financing activities
    
    
    2,229,842
    
    
    
    1,957,935
    
    
    
    7,167,781
    
    
    
    6,424,660Net (decrease) increase in cash and cash equivalents
    
    
    (738,814
    )
    
    
    154,698
    
    
    
    51,658
    
    
    
    131,127Cash and cash equivalents at beginning of period
    
    
    875,838
    
    
    
    24,246
    
    
    
    85,366
    
    
    
    47,817Cash and cash equivalents at end of period
    
    $
    137,024
    
    
    $
    178,944
    
    
    $
    137,024
    
    
    $
    178,944
 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 September 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), its wholly owned bankruptcy-remote special purpose finance
subsidiary, Thornburg Mortgage Depositor, LLC (TMD), its wholly owned
mortgage loan origination subsidiary, Thornburg Mortgage Home Loans, Inc.
(TMHL), TMDs wholly owned special purpose finance subsidiary, Thornburg
Mortgage Capital Resources, LLC (TMCR) and TMHLs two wholly owned
special purpose finance subsidiaries, Thornburg Mortgage Funding
Corporation II and Thornburg Mortgage Acceptance Corporation II. 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. 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 was intended to eliminate the diversity
in industry practice that existed 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 (FASB) 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 was
to be applicable to other-than-temporary impairment evaluations in
reporting periods beginning after June 15, 2004. In September 2004, the
FASB proposed additional guidance related to debt securities that are
impaired because of interest rate and /or sector spread increases, and
delayed the effective date of EITF 03-01. 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 disclosure 8




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requirements for investments in an unrealized loss position for which
other-than-temporary impairments have not been recognized. These
disclosures are included in the Companys Form 10-Q Quarterly Report for
the quarter ended September 30, 2004 as required by the EITF.On March 31, 2004, the FASB issued an exposure draft (the ED) entitled
Share-Based Payment. If the ED is adopted by the FASB, it would require
all public companies to report share-based compensation expense at the
grant date fair value of the related share-based awards. In October 2004,
the FASB delayed the effective date of this proposed standard. Public
companies with calendar year-ends would be required to adopt the
provisions of the standard effective for periods beginning after June 15,
2005. Management believes that the Companys method of accounting for
share-based payments is consistent with the guidance provided by the ED. 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 value 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,
asset-backed commercial paper 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 reserve
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. 9




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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 longer or shorter than the amount estimated by 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 prepayment speeds, 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 longer or shorter
than the amount estimated by management. Credit risk and reserve for loan losses  The Company limits its exposure to credit losses on its portfolio of ARM
securities by purchasing ARM securities that generally have at least 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 risk. 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 10




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##### Table of Contents



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 a reserve for loan losses based on managements
estimate of credit losses inherent in the Companys portfolio of ARM
Loans. The estimation of the reserve 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 reserve 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 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 interest 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 price the Companys originated ARM Loans,
adjusted for anticipated fallout for purchase loan 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 collateralized debt obligations (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,
asset-backed commercial paper, 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 11




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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.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 ARM 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 ARM 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. Consequently, the Company uses Hybrid ARM
Hedging Instruments to fix the interest rate on its borrowings during the
expected fixed interest rate period of the Companys Hybrid ARM assets
such that the Company maintains a combined duration on its borrowings and
Hybrid ARM Hedging Instruments that closely matches the duration of the
Companys Hybrid ARM assets, the difference being net duration. The
notional balances of the Hybrid ARM 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. When the Company enters into a Eurodollar Transaction, it
incurs a gain if the applicable interest rate index subsequently rises and
a loss if the applicable interest rate index subsequently declines. The
amortization of the gain or loss over the hedged period when combined with
the variable cost of the short-term debt is expected to result in a fixed
interest cost over the life of the Eurodollar Transaction.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 so as not to exceed the 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 ARM 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 ARM
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 ARM Hedging Instruments is included in Hedging
instruments on the Consolidated Balance Sheets. 12




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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 InstrumentsIn the past, the Company has purchased 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). The Company has discontinued its policy to separately
hedge the Life Cap on Traditional ARM assets and, instead, manages this
risk as part of the overall management of portfolio duration.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 $65.0 million and
$7.9 million at September 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. Since being
converted to taxable REIT subsidiaries, TMHL and its subsidiaries have
recorded an immaterial amount of income and have not recorded 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 13




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##### Table of Contents



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 nine-month periods ended September 30, 2004 and 2003 (in
thousands except per share data): EarningsIncome
    
    Shares
    
    Per ShareThree Months Ended September 30, 2004Net income
    
    $
    58,029Basic and Diluted EPS, income available to
common shareholders
    
    $
    58,029
    
    
    
    84,643
    
    
    $
    0.69Three Months Ended September 30, 2003Net income
    
    $
    45,768Basic and Diluted EPS, income available to
common shareholders
    
    
    45,768
    
    
    
    66,092
    
    
    $
    0.69Effect of dilutive securities:Convertible preferred stock
    
    
    
    
    
    
    1,440Diluted EPS
    
    $
    45,768
    
    
    
    67,532
    
    
    $
    0.68
 EarningsIncome
    
    Shares
    
    Per ShareNine Months Ended September 30, 2004Net income
    
    $
    169,291Basic and Diluted EPS, income available to
common shareholders
    
    $
    169,291
    
    
    
    80,896
    
    
    $
    2.09Nine Months Ended September 30, 2003Net income
    
    $
    127,034Less preferred stock dividends
    
    
    (3,340
    )Basic EPS, income available to common shareholders
    
    
    123,694
    
    
    
    60,572
    
    
    $
    2.04Effect of dilutive securities:Convertible preferred stock
    
    
    3,340
    
    
    
    2,315Diluted EPS
    
    $
    127,034
    
    
    
    62,887
    
    
    $
    2.02
 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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Note 2. Adjustable-Rate Mortgage Assets  The following tables present the Companys ARM assets as of September
30, 2004 and December 31, 2003 (in thousands): ARM loans
    
    ARM loansARM
    
    Securitized
    
    collateralizing
    
    held forSeptember 30, 2004
    
    securities
    
    ARM loans
    
    debt obligations
    
    securitization
    
    TotalPrincipal balance outstanding
    
    $
    16,488,957
    
    
    $
    3,068,875
    
    
    $
    5,832,951
    
    
    $
    456,500
    
    
    $
    25,847,283Net unamortized premium
    
    
    253,714
    
    
    
    16,758
    
    
    
    31,346
    
    
    
    4,086
    
    
    
    305,904Loan loss reserves
    
    
    
    
    
    
    (7,306
    )
    
    
    (1,586
    )
    
    
    (250
    )
    
    
    (9,142
    )Basis adjustments
    
    
    (4,960
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (4,960
    )Net unrealized gain on
purchase loan commitments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    913
    
    
    
    913Principal payment receivable
    
    
    29,285
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    29,285Amortized cost, net
    
    
    16,766,996
    
    
    
    3,078,327
    
    
    
    5,862,711
    
    
    
    461,249
    
    
    
    26,169,283Gross unrealized gains
    
    
    31,532
    
    
    
    12,030
    
    
    
    81,247
    
    
    
    2,017
    
    
    
    126,826Gross unrealized losses
    
    
    (160,586
    )
    
    
    (28,719
    )
    
    
    
    
    
    
    (1,586
    )
    
    
    (190,891
    )Fair value
    
    $
    16,637,942
    
    
    $
    3,061,638
    
    
    $
    5,943,958
    
    
    $
    461,680
    
    
    $
    26,105,218Carrying value
    
    $
    16,637,942
    
    
    $
    3,078,327
    
    
    $
    5,862,711
    
    
    $
    461,249
    
    
    $
    26,040,229
 ARM loans
    
    ARM loansARM
    
    Securitized
    
    collateralizing
    
    held forDecember 31, 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 $7.6 million during the nine months ended September 30, 2004. This
gain consists of an $11.1 million gain on the sale of $1.1 billion of
ARM assets and a $2.1 million realized gain on the termination of three
Swap Agreements, partially offset by a net loss of $1.8 million on
Eurodollar Transactions hedging the loan commitment pipeline and a net
loss of $3.8 million on commitments to purchase loans from
correspondent lenders and bulk sellers. The Company realized a gain on
ARM assets of $5.4 million during the nine months ended September 30,
2003. This gain consists of a $2.7 million net recovery of estimated
credit losses, a $1.8 million net gain on the loan commitments pipeline
at September 30, 2003 and a $910.5 thousand gain upon the maturity of a
collateralized bond obligation.During the nine months ended September 30, 2004, the Company
securitized $3.4 billion of its ARM loans into a series of
private-label multi-class ARM securities. The Company retained $75.2
million of the securities created for its securitized ARM loan
portfolio and placed $3.4 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, $57.7
million were rated Investment Grade and $17.5 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 September 30, 2004, the Company had
$9.0 billion of ARM assets as a result of the Companys securitization
efforts. As of December 31, 2003, the Company had $6.9 billion of ARM
assets as a result of the Companys securitization efforts. 15




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##### Table of Contents



MSRs capitalized upon the securitization of $3.4 billion of ARM loans
during the nine months ended September 30, 2004 totaled $12.3 million.
MSRs of $18.0 million, net of amortization during the nine months ended
September 30, 2004 of $3.0 million, are included in Prepaid expenses
and other on the Consolidated Balance Sheets at September 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 September 30, 2004, the fair value of the MSRs in each risk
stratum exceeded their cost basis.As of September 30, 2004 and December 31, 2003, the Company had basis
adjustments of $5.0 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 $2.3 million related to ARM securities purchased during
the first nine months of 2004 on which the Company had first loss
credit exposure. These securities were purchased as part of $1.7
billion of third party loan securitizations in which the Company
purchased all classes of the securitizations, including the
subordinated classes.During the nine months ended September 30, 2004, the Company recorded
loan loss provisions totaling $1.1 million to reserve for estimated
credit losses on ARM Loans bringing its total loan loss reserve to $9.1
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
436 individual securities have been in a continuous unrealized loss
position, at September 30, 2004 (dollar amounts in thousands): Unrealized Losses on ARM Securities as of September 30, 2004 Less Than 12 Months
    
    12 Months or More
    
    TotalUnrealized
    
    
    
    
    
    Unrealized
    
    Fair
    
    UnrealizedFair Value
    
    Loss
    
    Fair Value
    
    Loss
    
    Value
    
    LossAgency Securities
    
    $
    968,639
    
    
    $
    (5,874
    )
    
    $
    239,899
    
    
    $
    (4,409
    )
    
    $
    1,208,538
    
    
    $
    (10,283
    )AAA/Aaa Rating
    
    
    7,692,898
    
    
    
    (96,016
    )
    
    
    1,729,965
    
    
    
    (43,295
    )
    
    
    9,422,863
    
    
    
    (139,311
    )AA/Aa Rating
    
    
    78,023
    
    
    
    (785
    )
    
    
    40,551
    
    
    
    (8,771
    )
    
    
    118,574
    
    
    
    (9,556
    )A Rating
    
    
    20,460
    
    
    
    (251
    )
    
    
    1,887
    
    
    
    (13
    )
    
    
    22,347
    
    
    
    (264
    )BBB/Baa Rating
    
    
    8,572
    
    
    
    (143
    )
    
    
    4,541
    
    
    
    (788
    )
    
    
    13,113
    
    
    
    (931
    )BB/Ba Rating and
Below
    
    
    5,847
    
    
    
    (168
    )
    
    
    1,158
    
    
    
    (73
    )
    
    
    7,005
    
    
    
    (241
    )Total
    
    $
    8,774,439
    
    
    $
    (103,237
    )
    
    $
    2,018,001
    
    
    $
    (57,349
    )
    
    $
    10,792,440
    
    
    $
    (160,586
    )
  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 the Company has the ability and intent to
hold its ARM securities, losses are not considered to be other than
temporary impairments. As presented in Note 7, during the nine-month
period ended September 30, 2004, the net unrealized loss of $43.3
million on ARM securities increased by $85.9 million to a net
unrealized loss of $129.2 million. During the same nine-month period,
the net unrealized loss on hedging instruments of $99.5 million
improved by $72.8 million to a net unrealized loss of $26.7 million,
for a combined increase in the net unrealized loss on ARM securities
and hedging instruments of $13.1 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 September 30, 2004 and
December 31, 2003 (in thousands, except for loan count): September 30, 2004 Percent 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
    
    
    8
    
    
    
    2,186
    
    
    
    0.02
    
    
    
    0.018
    
    
    $
    2,186
    
    
    
    0.02
    %
    
    
    0.01
    %
 December 31, 2003 Percent 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 September 30, 2004, the Company owned one real estate property as
a result of foreclosing on a delinquent loan that is included in ARM
loans on the Consolidated Balance Sheet in the aggregate amount of
$203.5 thousand (not included in the table above.) The Company
believes that its current level of reserves is adequate to cover any
loss, should one occur, from the sale of this property and losses
inherent within the loan portfolio.As of September 30, 2004, the Company had commitments to purchase or
originate the following amounts of ARM assets (in thousands): ARM securities  agency
    
    $
    506,523ARM securities  private high quality
    
    
    1,363,552ARM securities  other
    
    
    14,590ARM loans  correspondent originations
    
    
    625,503ARM loans  direct originations
    
    
    104,459$
    2,614,627
  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. At September 30, 2004, the balance
of the Hybrid ARM securities was approximately $1.6 billion, but is
expected to be less than 30% of that, and could be zero, at the time
they convert into Traditional ARM securities. At September 30, 2004,
the remaining balance of securities to be acquired in 2004 was
approximately $15.0 million and may pay down to zero by the purchase
commitment date. 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
September 30, 2004, the Company had delivered ARM
assets with a carrying value of $6.1 million and $3.3 million in cash
as collateral in connection with these transactions. 17




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##### Table of Contents



Note 3. Hedging Instruments Hybrid ARM Hedging Instruments  As of September 30, 2004 and December 31, 2003, the Company was
counterparty to Hybrid ARM Hedging Instruments that consist of Swap
Agreements and Eurodollar Transactions having aggregate current
notional balances of $18.6 billion and $12.5 billion, respectively. In
addition, as of September 30, 2004, the Company had entered into
delayed Swap Agreements with notional balances totaling $1.5 billion
that become effective in the fourth quarter of 2004. These delayed
Swap Agreements have been entered into to hedge the financing of the
Companys ARM asset purchase commitments at September 30. 2004.. As of
September 30, 2004, these Swap Agreements and Eurodollar Transactions
had a weighted average maturity of 3.0 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 3.06% and 3.02% at September 30, 2004 and December 31, 2003,
respectively. As of September 30, 2004, ARM assets with a carrying
value of $73.6 million, including accrued interest, and cash totaling
$42.4 million collateralized the Swap Agreements and Eurodollar
Transactions.The net unrealized loss on Swap Agreements at September 30, 2004 of
$2.0 million included Swap Agreements with gross unrealized losses of
$67.0 million and gross unrealized gains of $65.0 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 September 30, 2004, the net
unrealized loss on Swap Agreements and deferred gains and losses on
Eurodollar Transactions recorded in Accumulated other comprehensive
income (loss) was a net loss of $7.2 million. The Company estimates
that over the next twelve months, $32.7 million of these net unrealized
losses will be reclassified from Accumulated other comprehensive income
(loss) to interest expense.As of September 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 $1.3 billion and $1.6 billion,
respectively. The Company has also entered into Cap Agreements that
have start dates ranging from 2006 to 2010. The notional balance at
the start date will be the lesser of the scheduled amount of $371.1
million or the balance of Hybrid ARM loans associated with these Cap
Agreements. The fair value of all of these Cap Agreements at September
30, 2004 and December 31, 2003 was $16.9 million and $25.4 million,
respectively, and is included in Hedging instruments on the
Consolidated Balance Sheets. As of September 30, 2004, the unrealized
loss on these Cap Agreements of $19.4 million is included in
Accumulated other comprehensive income (loss). In the twelve month
period following September 30, 2004, $337.8 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
5.24%. The Cap Agreements had an average maturity of 4.2 years as of
September 30, 2004 and will expire between 2006 and 2013.The Company hedges the funding of its Hybrid ARM assets such that the
net duration, which is the duration of borrowed funds and Hybrid ARM
Hedging Instruments minus the duration of Hybrid ARM assets, is less
than one year. See a discussion of duration and net duration under
Portfolio Strategies on page 32. At September 30, 2004, the financing
and hedging of the Companys Hybrid ARM assets resulted in a net
duration of approximately 2.9 months while the financing and hedging of
all of the Companys ARM assets resulted in a net duration of
approximately 2.6 months. This suggests a very low degree of portfolio
price change given small changes in interest rates, and implies that
the Companys cash flow and earning characteristics should be
relatively stable as interest rates change. 18




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##### Table of Contents



Interest expense for the quarter and nine-month period ended September
30, 2004 includes net payments on Hybrid ARM Hedging Instruments of
$62.5 million and $190.8 million, respectively. Interest expense for
the same periods in 2003 includes net payments on Hybrid ARM Hedging
Instruments of $40.9 million and $107.6 million, respectively. Life Cap Hedging Instruments  The Life Cap Hedging Instruments had a fair value of $0 at September
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 $200.0 million and $841.3 million as of September 30, 2004 and
December 31, 2003, respectively. The Company will receive cash
payments should the three-month LIBOR increase above the contract rates
of these Hedging Instruments, which range from 8.00% to 8.25% and
average 8.13%. The Life Cap Hedging Instruments had an average final
maturity of 3.2 months as of September 30, 2004 and expire in January
2005. During the three- and nine-month periods ended September 30,
2004, the Company recognized expenses of $149.2 thousand and $456.5
thousand, respectively, which is reported as Hedging expense in the
Companys Consolidated Income Statements. During the three- and
nine-month periods ended September 30, 2003, the Company recognized
expenses of $145.0 thousand and $541.8 thousand, respectively. Pipeline Hedging Instruments  The fair value of the Pipeline Hedging Instruments at September 30,
2004 and December 31, 2003 was a net unrealized loss of $5.1 million
and a net unrealized gain of $953.4 thousand, respectively, and is
included in Hedging instruments on the Consolidated Balance Sheets.
Pipeline Hedging Instruments had remaining notional balances of $357.0
million and $283.0 million at September 30, 2004 and December 31, 2003,
respectively. During the three- and nine-month periods ended September
30, 2004, the Company recognized a $8.3 million loss and a $1.8 million
loss, 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 along with a $5.4 million gain
and a $3.8 million loss recorded on loan commitments for the three- and
nine-month periods ended September 30, 2004, respectively. 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 September 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 September 30, 2004, the Company had $15.1 billion of reverse
repurchase agreements outstanding with a weighted average borrowing
rate of 1.89% and a weighted average remaining maturity of 2.7 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 September 30, 2004, $13.2 billion of the Companys borrowings
were variable-rate term reverse repurchase agreements with original
maturities that range from two 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 $12.2 billion, including accrued interest,
collateralized the reverse repurchase agreements at September 30, 2004.
The Company held cash collateral from reverse repurchase agreement
counterparties totaling $12.2 million at September 30, 2004. 19




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##### Table of Contents



At September 30, 2004, the reverse repurchase agreements had the
following remaining maturities (in thousands): Within 30 days
    
    $
    4,496,88931 to 89 days
    
    
    6,771,52490 to 365 days
    
    
    3,824,902$
    15,093,315
 Asset-backed Commercial Paper Facility  On June 30, 2004, the Company established a new $5 billion asset-backed
commercial paper facility, which provides an alternative way to finance
the Companys high quality ARM securities portfolio. Through a wholly
owned bankruptcyremote special purpose subsidiary, the Company issues
asset-backed commercial paper to investors in the form of secured
liquidity notes that are recorded as borrowings on the Companys
Consolidated Balance Sheets and are rated P-1 by Moodys Investors
Services and F1+ by Fitch Ratings. As of September 30, 2004, the
Company had $3.2 billion of asset-backed commercial paper outstanding
with a weighted average interest rate of 1.85% and a weighted average
remaining maturity of 27 days.  As of September 30, 2004, these notes were collateralized by AAA-rated
mortgage-backed securities from the Companys ARM securities portfolio
with a carrying value of $3.4 billion, including accrued interest. CDOs  On September 29, 2004, $1.3 billion of ARM loans from the Companys ARM
loan portfolio were transferred to Thornburg Mortgage Securities Trust
2004-3 and were securitized. In this transaction, the Company through
its securities underwriter issued AAA-rated floating-rate pass-through
certificates totaling $1.2 billion to third party investors and the
Company 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 connection with the issuance of these
CDOs, the Company incurred costs of $4.0 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 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 September 30, 2004, the following CDOs were outstanding (in
thousands): EffectiveInterestDescription
    
    Principal Balance
    
    Rate (1)Floating-rate financing (2)
    
    $
    3,150,453
    
    
    
    2.28
    %Fixed-rate financing
    
    
    2,651,323
    
    
    
    4.05
    %Total
    
    $
    5,801,776
    
    
    
    3.09
    %
  (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 $1.3 billion and a weighted average strike
price of 5.24% as of September 30, 2004.  As of September 30, 2004, the CDOs were collateralized by ARM loans
with a principal balance of $5.8 billion. The debt matures between
2033 and 2044 and is callable by the Company at par once the total
balance of the 20




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##### Table of Contents



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 September 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 November 2004
and March 2005. The Company expects to renew these facilities. As of
September 30, 2004, the Company had $297.5 million borrowed against
these whole loan financing facilities at an effective cost of 2.76%.
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 September
30, 2004 was collateralized by ARM loans with a carrying value of
$308.5 million, including accrued interest. These facilities have
covenants that are standard for industry practice and the Company was
in compliance with all such covenants at September 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
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 September 30, 2004 and December
31, 2003, the balance of the Senior Notes outstanding, net of
unamortized issuance costs, was $251.4 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 September 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 $155.6 million and $85.7 million
for the quarters ended September 30, 2004 and 2003, respectively, and
$421.7 million and $232.3 million for the nine months ended September
30, 2004 and 2003, respectively. 21




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##### Table of Contents



Contractual Obligations  As of September 30, 2004, the Company 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
    
    $
    15,093,315
    
    
    $
    15,093,315
    
    
    $
    
    
    
    $
    
    
    
    $
    Asset-backed commercial paper
    
    
    3,184,489
    
    
    
    3,184,489CDOs (1)
    
    
    5,801,776
    
    
    
    10,850
    
    
    
    25,073
    
    
    
    55,400
    
    
    
    5,710,453Whole loan financing facilities
    
    
    297,470
    
    
    
    297,470
    
    
    
    
    
    
    
    
    
    
    
    Senior Notes
    
    
    251,400
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    251,400Purchase commitments
    
    
    2,614,627
    
    
    
    2,614,627
    
    
    
    
    
    
    
    
    
    
    
    Total (2)
    
    $
    27,243,077
    
    
    $
    21,200,751
    
    
    $
    25,073
    
    
    $
    55,400
    
    
    $
    5,961,853
  (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. 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 September 30, 2004 and
December 31, 2003 (in thousands): September 30, 2004
    
    December 31, 2003Carrying
    
    Fair
    
    Carrying
    
    FairAmount
    
    Value
    
    Amount
    
    ValueAssets:ARM securities
    
    $
    16,637,942
    
    
    $
    16,637,942
    
    
    $
    11,520,741
    
    
    $
    11,520,741Securitized ARM loans
    
    
    3,078,327
    
    
    
    3,061,638
    
    
    
    3,687,466
    
    
    
    3,703,420ARM loans collateralizing CDOs
    
    
    5,862,711
    
    
    
    5,943,958
    
    
    
    3,146,961
    
    
    
    3,138,634ARM loans held for securitization
    
    
    461,249
    
    
    
    461,680
    
    
    
    496,998
    
    
    
    497,271Hedging instruments
    
    
    81,952
    
    
    
    81,952
    
    
    
    40,356
    
    
    
    40,356Liabilities:Reverse repurchase agreements
    
    
    15,093,315
    
    
    
    15,093,315
    
    
    
    13,926,858
    
    
    
    13,926,858Asset-backed commercial paper
    
    
    3,184,489
    
    
    
    3,184,489
    
    
    
    
    
    
    
    CDOs
    
    
    5,801,776
    
    
    
    5,811,531
    
    
    
    3,114,047
    
    
    
    3,134,560Whole loan financing facilities
    
    
    297,470
    
    
    
    297,470
    
    
    
    369,343
    
    
    
    369,343Senior Notes
    
    
    251,400
    
    
    
    265,200
    
    
    
    251,080
    
    
    
    267,750Hedging instruments
    
    
    79,545
    
    
    
    79,545
    
    
    
    113,518
    
    
    
    113,518
  As of September 30, 2004, the Company had no off-balance sheet credit
risk. 22




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##### Table of Contents



Note 6. Common Stock  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 three- and nine-month periods ended September 30, 2004, the
Company issued 2,303,600 and 4,188,300 shares, respectively, of common
stock through at-market transactions and received net proceeds of $64.2
million and $115.7 million, respectively, under controlled equity
offering programs.During the three- and nine-month periods ended September 30, 2004, the
Company issued 1,796,210 and 4,950,860 shares, respectively, of common
stock under the Dividend Reinvestment and Stock Purchase Plan (the
DRSPP) and received net proceeds of $49.9 million and $135.4 million,
respectively.As of September 30, 2004, $532.4 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. 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 accumulated 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
    
    
    (72,897
    )
    
    
    (26,297
    )
    
    
    (99,194
    )Balance, September 30, 2003
    
    $
    (29,408
    )
    
    $
    (175,040
    )
    
    $
    (204,448
    )Balance, December 31, 2003
    
    $
    (43,314
    )
    
    $
    (99,464
    )
    
    $
    (142,778
    )Net change
    
    
    (85,890
    )
    
    
    72,787
    
    
    
    (13,103
    )Balance, September 30, 2004
    
    $
    (129,204
    )
    
    $
    (26,677
    )
    
    $
    (155,881
    )
  The net unrealized gain on the Companys ARM Loans of $65.0 million and
$7.9 million at September 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 September 30, 2004, there were 1,495,647 DERs outstanding all of
which were vested, and 862,635 PSRs outstanding, of which 703,130 were
vested. The Company recorded expenses associated with DERs and PSRs of
$3.5 million and $2.3 million for the quarters ended September 30, 2004
and 2003, respectively. Of the expense recorded in the third quarter
of 2004, $1.6 million was the impact of the increase in the Companys 23




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common stock price on the value of the PSRs which was recorded as a
fair value adjustment, $1.5 million was associated with dividend
equivalents paid on DERs and PSRs and $448.3 thousand related to the
amortization of unvested PSRs. Of the expense recorded in the third
quarter of 2003, $1.2 million was the amount of dividend equivalents
paid on DERs and PSRs, $438.0 thousand was the amortization of unvested
PSRs, and $614.1 thousand 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 nine-month periods
ended September 30, 2004 and 2003, the Company recorded an expense
associated with DERs and PSRs in the amount of $7.7 million and $7.0
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). In July 2004, 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. These percentages are subject to adjustment each
July based on changes to the Consumer Price Index over the prior twelve
month period. 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.During the quarters ended September 30, 2004 and 2003, the Company
reimbursed the Manager $1.5 million and $1.0 million for expenses,
respectively, in accordance with the terms of the Agreement. During
the nine-month periods ended September 30, 2004 and 2003, the Company
reimbursed the Manager and other Thornburg entities $4.3 million and
$3.2 million for expenses, respectively. As of September 30, 2004 and
2003, $2.7 million and $2.0 million, respectively, was payable by the
Company to the Manager for these reimbursable expenses.For the quarters ended September 30, 2004 and 2003, the Company
incurred costs of $4.2 million and $3.1 million, respectively, in base
management fees in accordance with the terms of the Agreement. For the
nine-month periods ended September 30, 2004 and 2003, the Company
incurred base management fees of $11.7 million and $8.2 million,
respectively. As of September 30, 2004 and 2003, $1.4 million and $1.1
million, respectively, was payable by the Company to the Manager for
the base management fee.For the three-month periods ended September 30, 2004 and 2003, the
Manager earned performance-based compensation in the amount of $8.5
million and $7.1 million, respectively, in accordance with the terms of
the Agreement. For the nine-month periods ended September 30, 2004 and
2003, the Manager earned performance-based compensation in the amount
of $25.3 million and $20.2 million, respectively. As of September 30,
2004 and 2003, $8.5 million and $7.1 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 September 30, 2004, the
aggregate balance of these mortgage loans outstanding amounted to $37.8
million, had a weighted average interest rate of 3.78%, and maturities
ranging between 2030 and 2034. 24




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##### Table of Contents



Note 10. Subsequent Events  On October 19, 2004, the Company declared the third quarter 2004
dividend of $0.67 per share of common stock, which is payable on
November 17, 2004 to shareholders of record on November 4, 2004. 25




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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 to achieve earnings and
dividend stability as our primary objective and earnings and dividend growth as
our secondary objective. In order to achieve these objectives, we must
mitigate key risks inherent in the mortgage portfolio lending business,
principally credit risk and interest rate risk, while simultaneously pursuing
earnings growth strategies. Our three primary growth strategies are (i) to
increase our more profitable, higher margin 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 third quarter of 2004, our assets grew 8% from $24.5 billion at June
30, 2004 to $26.4 billion at September 30, 2004. Our net earnings increased 1%
from $0.68 per share for the third quarter of 2003 to $0.69 per share for the
third quarter of 2004. We raised $114.2 million of new equity capital during
the quarter by issuing 4.1 million common shares at an average net price of
$27.85 per share. Primarily as a result of raising this new common equity and
the retention of earnings, our book value per common share rose 19% from $15.91
per share at September 30, 2003 to $18.92 per share at September 30, 2004. 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 third quarter. We
acquired $4.3 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 32 for definition of High Quality). We saw a flattening
of the yield curve during the third quarter with short-term interest rates
increasing somewhat while longer-term rates decreased, and our portfolio
prepayment rate decreased to an average of 23% Constant Prepayment Rate (CPR)
from an average of 35% CPR in the prior quarter. 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 $1.2 billion in new assets during the quarter, an
increase of 18% from originations during the third quarter of 2003. As a
result of these ARM loan originations and acquisitions, as of September 30,
2004, we owned $9.4 billion of ARM Loans (see page 31 for definition of ARM
Loans), which amounted to 36% of our ARM assets. While the Mortgage Bankers Association (the MBA) is projecting a 30% decline
in overall originations in 2004 versus 2003, we expect to modestly exceed our
2003 loan production of $4.0 billion. We attribute our success to a growing
network of financial intermediaries, our competitive rates, innovative products
and strong service levels. 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 use of ARM loans. Over the past twelve months, we
have effectively grown our share of the mortgage market for home purchases.
Mortgages to finance the purchase of homes accounted for 69% of our loan
production in the third quarter of 2004, compared to 35% in the third quarter
of 2003. Our goal remains to grow our origination business over time, in both
absolute terms and as a percentage of our overall annual asset acquisitions so
that we can capitalize on the better margins generated by our mortgage
origination channels. Funding Diversification Our long-term objective is to achieve a balanced funding mix with commercial
paper, CDOs and reverse repurchase agreements. Historically we have been
reliant principally on reverse repurchase agreements for our funding needs.
Since year end 2002, we have been actively working towards diversifying our
financing sources. At that time, 91% of our financing was provided through
reverse repurchase agreements. At September 30, 2004, reverse repurchase
agreements only accounted for 61% of our borrowings, while CDOs grew to 24% and
our newly introduced asset-backed commercial paper facility 26




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accounted for 13%. We anticipate that CDOs and commercial paper will continue
to grow as a percentage of our financing sources in the quarters to come. 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. As of September 30, 2004, we issued $3.2
billion of asset-backed commercial paper in the form of secured liquidity notes
to investors that are recorded as borrowings on our Consolidated Balance
Sheets, and have been rated P-1 by Moodys Investors Service and F1+ by Fitch.
In September, we also completed our third securitization of the year. In this
transaction, $1.3 billion of ARM loans were permanently financed through the
issuance of CDOs. As of September 30, 2004, the $5.8 billion of CDO financing
outstanding required approximately 2% of equity capital, freeing up
approximately $434 million of capital for the acquisition of approximately $3.0
billion of additional ARM assets. Credit Quality We originate and acquire excellent credit quality ARM assets and securitize the
ARM loans. These strategies create significant portfolio liquidity and allow
us to readily finance our portfolio. As of September 30, 2004, 97.3% of our
ARM asset portfolio was High Quality as compared to 96.8% as of June 30, 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 third 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 16 months old
at September 30, 2004. Due to this lack of seasoning and, therefore, lack of
relevant historical data, we have recorded a loan loss reserve of $9.1 million
as of September 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 ARM 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 hedge our financing cost such that we
maintain a net duration, which is the duration of borrowed funds and Hybrid ARM
Hedging Instruments minus the duration of Hybrid ARM assets, of less than one
year. The lower the duration gap, the less impact interest rate changes should
have on earnings. As of September 30, 2004, we had entered into Swap
Agreements and Eurodollar Transactions with notional balances totaling $18.6
billion and delayed Swap Agreements with notional balances totaling $1.5
billion that become effective in the fourth quarter of 2004. These delayed
Swap Agreements have been entered into to hedge the financing of our ARM asset
purchase commitments at September 30, 2004. Additionally, at September 30,
2004, we had Cap Agreements with a notional balance of $1.3 billion. These Cap
Agreements do not receive any payments unless one-month LIBOR rises above a
range of 3.25% to 11.50%, and on average 5.24%. As a result, as of September
30, 2004, we measured the net duration applicable to our Hybrid ARM portfolio,
related borrowings and Hybrid ARM Hedging Instruments at approximately 2.9
months while the financing and hedging of all of the Companys ARM assets
resulted in a net duration of approximately 2.6 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. As
we acquire ARM assets, we essentially 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 on our
ARM assets, there is no sure way to lock-in a spread between the yield on our
ARM assets and the related borrowing that would produce an acceptable rate of
return. 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 59. 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 third quarter of 2004, our operating
expenses as a percent of average assets were 0.33%, compared to 0.39% for the
same quarter of 2003 and 0.28% during the second quarter of 2004. 27




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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 so we avoid the overhead associated with retail
branch networks and commissioned loan officers. We also do not acquire loans
through mortgage brokers. In addition, we have developed other outsourced
strategic partnerships that provide loan fulfillment 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 certain cyclical
risks frequently 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 elect either to securitize our
acquired and originated ARM loans or invest primarily in AAA- or AA-rated
securities, Agency Securities or A quality ARM loans. This strategy has
resulted in very low credit losses. It has also created a very liquid and
readily financeable 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 and retaining all of our ARM loans, we do not depend
on gain on sale income, which can fluctuate significantly with loan origination
volume and market conditions. The decrease in our earnings per share from $0.71 in the second quarter of 2004
to $0.69 in the third quarter of 2004 can be attributed to a decline in our
portfolio margin from 1.31% for the second quarter of 2004, to 1.18% during the
third quarter of 2004. Three primary factors contributed to the decline in our
average portfolio margin. First, the net interest spread on our six- and
twelve-month Traditional ARMs, which represent 12% of our portfolio, declined
as our funding costs related to those assets, which are based on one-month
LIBOR, increased during the quarter. We believe this margin decline is
temporary as these assets will continue to reprice upwards over the next six to
twelve months. Second, we also continued to increase our hedged borrowing
position against our Hybrid ARMs during the quarter to further reduce our
exposure to rising interest rates on that portion of our portfolio. Since
December 31, 2003, our fixed rate and hedged borrowings have grown from 90.1%
of Hybrid ARM assets to 94.3% at September 30, 2004. This increase reflects
our expectation that interest rates will rise and our objective to minimize the
impact of such an increase on earnings. Third, we have entered into Cap
Agreements to hedge the borrowings on $1.3 billion of CDO financing. These Cap
Agreements will cap our variable rate financing cost on certain Hybrid ARM
assets at a level specified in the Cap Agreements, but in the interim as
interest rates rise these variable rate borrowing costs are not fixed, so our
margin is declining on these assets. See further discussion of the change in
our interest rate spreads in Results of Operations For the Three Months Ended
September 30, 2004, beginning on page 49 and Results of Operations For the
Nine Months Ended September 30, 2004, beginning on page 55. 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
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: 28




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##### Table of Contents




    
    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 Thornburg Mortgage Advisory Corporation (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 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. See discussion of Management Agreement amendment on
page 54.
    
    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, changes in
beneficial ownership forms 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. 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 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 ARM Hedging Instruments at fair value. The fair values
of our ARM securities and Hybrid ARM Hedging Instruments are generally
based on market prices provided by third party pricing services or certain
dealers which 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 29




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##### Table of Contents



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 of purchase loan 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 a reserve for loan losses
based on managements estimate of credit losses inherent in our portfolio
of ARM Loans. The estimation of the reserve 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 reserve 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
loan loss reserves using different assumptions (in thousands): Changed Assumption
    
    Increase (Decrease)in Loan Loss ReservesDefault assumption increased by 10%
    
    $
    1,460Default assumption decreased by 10%
    
    $
    (1,462
    )Loss severity assumption increased by 5%
    
    $
    1,760Loss severity assumption decreased by 5%
    
    $
    (1,760
    )
  The purpose of this analysis is to provide an indication of the impact that
defaults and loss severity assumptions have on our estimate of loan loss
reserves. 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. We review
ARM securities periodically for impairment and record or adjust basis
adjustments accordingly. 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.  
    
    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. 30




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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, asset-backed commercial paper, whole loan
financing facilities, 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 are intended to 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 45 for a
calculation of our Adjusted Equity-to-Assets Ratio.) Since all of the assets
we hold are ARM assets and we generally 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 150 approved 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 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. 31




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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, which is the duration of borrowed funds
and Hybrid ARM Hedging Instruments minus the duration of Hybrid ARM assets, of
less than one year. 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 ARM
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 ARM 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 income will be
affected. Prepayments generally increase when current mortgage interest rates
fall below the interest rates on existing 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. 32




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##### Table of Contents



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 which we have approved and which originate the
individual loans using our product pricing, underwriting criteria and
guidelines, or other approved criteria and guidelines. 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 and originate 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. We issue securities through
our securities underwriter to finance our loans and either retain these
securities or we may, at times, 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 third quarter of 2004, we modified 101 loans with balances totaling $61.4
million. Financing Strategies We finance our ARM assets using equity capital, unsecured debt, short-term
borrowings such as reverse repurchase agreements, asset-backed commercial
paper, CDOs, whole loan financing facilities and other collateralized
financings that we may establish with approved institutional lenders. See
Hedging Strategiesbelow for a discussion of how we convert short-term
borrowings into the equivalent of long-term fixed-rate financing for 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 two to twenty-five months.
The interest rates on these variable rate term reverse repurchase 33




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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. On June 30, 2004, we established a new $5 billion asset-backed commercial paper
facility, which provides us with an alternative way to finance our high quality
ARM securities portfolio. Through a bankruptcy-remote facility, we 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 have replaced a
portion of our reverse repurchase agreement borrowings with the issuance of
asset-backed commercial paper under terms that are comparable to our existing
reverse repurchase agreement funding. 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. 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,
asset-backed commercial paper and whole loan financing facilities. These forms
of borrowing are short-term in nature, mature on a frequent basis (weighted
average maturity of 2.4 months as of September 30, 2004), need to be rolled
over at each maturity and are subject to margin calls 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 margin requirements
typically average between 4% and 5% for these borrowings, so our policy
requires that we maintain capital of at least 8%, but we typically maintain 9%
to 10%, against the financing of these assets. We generally maintain a capital
cushion equal to approximately twice the margin requirement when using these
forms of borrowings. This capital 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. This eliminates the need to maintain a capital cushion
comparable to what we maintain on our recourse borrowings. 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 46.) Because the CDOs only require approximately 2% of equity
capital to support the CDO 34




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financing, versus the minimum 8% 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 ARM Hedging
Instruments that fix the interest rate on the borrowings such that the net
duration, which is the duration of borrowed funds and Hybrid ARM Hedging
Instruments minus the duration of Hybrid ARM assets, is less than one year. 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 specified
level as opposed to fixing our cost of funds as in a swap transaction. The
notional balances of the Hybrid ARM Hedging Instruments generally decline over
the life of these instruments. As of September 30, 2004, our Hybrid ARM
Hedging Instruments had a remaining average term to maturity of 3.1 years
before considering the effects of prepayments and when combined with our Hybrid
ARM assets and related borrowings had a net duration of approximately 2.9
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, in the past we have 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 September 30, 2004, we will receive
cash payments if the applicable index, the three-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 have discontinued the policy of specifically hedging the maximum
lifetime interest rate cap on Traditional ARM assets because 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
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 September 30, 2004, $2.9 billion of
our Traditional ARM assets have periodic caps, representing 10.7% 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 or principal-only mortgage derivative assets or
other mortgage derivative products for purposes of mitigating risk from
interest rate changes. We may also use, from time to time, futures 35




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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 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. 36




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Financial Condition Asset Quality At September 30, 2004, we held total assets of $26.4 billion, $26.0 billion of
which were 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 September 30, 2004, 97.2% 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 September 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) September 30, 2004ARM Securities
    
    ARM Loans
    
    TotalCarrying
    
    Portfolio
    
    Carrying
    
    
    
    
    
    Portfolio
    
    Carrying
    
    
    
    
    
    PortfolioValue
    
    Mix
    
    Value
    
    
    
    
    
    Mix
    
    Value
    
    
    
    
    
    MixHigh QualityAgency Securities
    
    $
    2,411,777
    
    
    
    14.5
    %
    
    $
    1,741
    
    
    
    
    
    
    
    0.0
    %
    
    $
    2,413,518
    
    
    
    
    
    
    
    9.3
    %Non-Agency ARM Assets:AAA/Aaa Rating
    
    
    13,981,453
    
    
    
    84.1
    
    
    
    8,649,345
    
    
    
    (1
    )
    
    
    92.0
    
    
    
    22,630,798
    
    
    
    (1
    )
    
    
    86.9AA/Aa Rating
    
    
    171,706
    
    
    
    1.0
    
    
    
    130,867
    
    
    
    
    
    
    
    1.4
    
    
    
    302,573
    
    
    
    
    
    
    
    1.1Total Non-Agency ARM Assets
    
    
    14,153,159
    
    
    
    85.1
    
    
    
    8,780,212
    
    
    
    
    
    
    
    93.4
    
    
    
    22,933,371
    
    
    
    
    
    
    
    88.0Total High Quality
    
    
    16,564,936
    
    
    
    99.6
    
    
    
    8,781,953
    
    
    
    
    
    
    
    93.4
    
    
    
    25,346,889
    
    
    
    
    
    
    
    97.3Other InvestmentsNon-Agency ARM Assets:A Rating
    
    
    37,504
    
    
    
    0.2
    
    
    
    69,553
    
    
    
    
    
    
    
    0.7
    
    
    
    107,057
    
    
    
    
    
    
    
    0.4BBB/Baa Rating
    
    
    19,125
    
    
    
    0.1
    
    
    
    35,096
    
    
    
    
    
    
    
    0.4
    
    
    
    54,221
    
    
    
    
    
    
    
    0.2BB/Ba Rating and Below
    
    
    16,377
    
    
    
    0.1
    
    
    
    63,328
    
    
    
    (1
    )
    
    
    0.7
    
    
    
    79,705
    
    
    
    (1
    )
    
    
    0.3ARM loans pending securitization
    
    
    
    
    
    
    0.0
    
    
    
    461,499
    
    
    
    
    
    
    
    4.9
    
    
    
    461,499
    
    
    
    
    
    
    
    1.8Total Other Investment
    
    
    73,006
    
    
    
    0.4
    
    
    
    629,476
    
    
    
    
    
    
    
    6.7
    
    
    
    702,482
    
    
    
    
    
    
    
    2.7Loan Loss Reserves
    
    
    
    
    
    
    0.0
    
    
    
    (9,142
    )
    
    
    
    
    
    
    (0.1
    )
    
    
    (9,142
    )
    
    
    
    
    
    
    (0.0
    )Total ARM Portfolio
    
    $
    16,637,942
    
    
    
    100.0
    %
    
    $
    9,402,287
    
    
    
    
    
    
    
    100.0
    %
    
    $
    26,040,229
    
    
    
    
    
    
    
    100.0
    %
  (1)
    
    As of September 30, 2004, the AAA Rating category includes $5.9
billion of ARM loans collateralizing CDOs that have been credit enhanced
to AAA through overcollateralization in the amount of $43.0 million
which is included in the BB/Ba Rating and below category. 37




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##### Table of Contents



December 31, 2003ARM Securities
    
    ARM Loans
    
    TotalCarrying
    
    Portfolio
    
    Carrying
    
    
    
    
    
    Portfolio
    
    Carrying
    
    
    
    
    
    PortfolioValue
    
    Mix
    
    Value
    
    
    
    
    
    Mix
    
    Value
    
    
    
    
    
    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
    %
  (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 September 30, 2004, 8 of the 20,441 loans in our ARM loan portfolio were
considered seriously delinquent (60 days or more delinquent) and had an
aggregate balance of $2.2 million. At September 30, 2004, the ARM loan
portfolio included one real estate-owned property totaling approximately $203.5
thousand that we acquired as a result of foreclosure procedures. The average
original effective loan-to-value ratio on the delinquent loans and the acquired
property was 75%. We believe that our current level of reserves for loan
losses is adequate to cover estimated losses from these loans. 38




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##### Table of Contents



ARM Loan Portfolio Characteristics The following table presents various characteristics of our ARM Loan portfolio
as of September 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 $9.4
billion. Average
    
    High
    
    LowOriginal loan balance
    
    $
    469,086
    
    
    $
    8,000,000
    
    
    $
    25,100Unpaid principal balance
    
    $
    458,444
    
    
    $
    8,000,000
    
    
    $
    1,988Coupon rate on loans
    
    
    4.33
    %
    
    
    9.13
    %
    
    
    1.64
    %Pass-through rate
    
    
    4.22
    %
    
    
    8.60
    %
    
    
    1.62
    %Pass-through margin
    
    
    1.92
    %
    
    
    4.73
    %
    
    
    0.23
    %Lifetime cap
    
    
    10.38
    %
    
    
    19.90
    %
    
    
    7.13
    %Original term (months)
    
    
    360
    
    
    
    480
    
    
    
    120Remaining term (months)
    
    
    344
    
    
    
    479
    
    
    
    21
 Geographic distribution (top 5 states):California
    
    
    26.2
    %Georgia
    
    
    10.6Florida
    
    
    8.1Colorado
    
    
    7.6New York
    
    
    7.5Occupancy status:Owner occupied
    
    
    80.1
    %Second home
    
    
    14.0Investor
    
    
    5.9Documentation type:Full/Alternative
    
    
    92.6
    %Other
    
    
    7.4Loan purpose:Purchase
    
    
    42.4
    %Cash out refinance
    
    
    28.8Rate & term
refinance
    
    
    28.8Original effective
loan-to-value:80.01% and over (2)
    
    
    2.7
    %70.01%-80.00%
    
    
    44.860.01%-70.00%
    
    
    24.450.01%-60.00%
    
    
    12.350.00% or less
    
    
    15.8Weighted average effective
original loan-to-value:
    
    
    66.3
    %Property type:Single-family
    
    
    84.6
    %Condominium
    
    
    13.2Other residential
    
    
    2.2ARM Loan type:Traditional ARM loans
    
    
    33.3
    %Hybrid ARM loans
    
    
    66.7ARM Interest Rate Caps:Initial Cap on Hybrid loans:3.00% or less
    
    
    1.7
    %3.01%-4.00%
    
    
    22.24.01%-5.00%
    
    
    60.55.01%-6.00%
    
    
    15.6Periodic Cap on Traditional ARM loans:None
    
    
    40.0
    %1.00% or less
    
    
    42.9Over 1.00%
    
    
    17.1Percent of interest-only loan
balances
    
    
    88.3
    %Weighted average length of
interest-only period
    
    8.2 yearsFICO scores:801 and over
    
    
    2.6
    %751 to 800
    
    
    42.3701 to 750
    
    
    33.9651 to 700
    
    
    18.2650 or less
    
    
    3.0Weighted 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.  (2)
    
    All loans with an effective original loan-to-value ratio over 80%
have mortgage insurance. 39




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##### Table of Contents



As of September 30, 2004 and December 31, 2003, we serviced $6.7 billion and
$4.7 billion of our loans, respectively, and had 14,397 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) September 30, 2004
    
    December 31, 2003Carrying
    
    Portfolio
    
    Carrying
    
    PortfolioValue
    
    Mix
    
    Value
    
    MixTraditional ARM assets:Index:One-month LIBOR
    
    $
    1,032,400
    
    
    
    4.0
    %
    
    $
    598,989
    
    
    
    3.2
    %Six-month LIBOR
    
    
    1,803,570
    
    
    
    6.9
    
    
    
    1,214,075
    
    
    
    6.4One-year LIBOR
    
    
    500,086
    
    
    
    1.9
    
    
    
    563,419
    
    
    
    3.0One-year Constant Maturity Treasury
    
    
    585,926
    
    
    
    2.3
    
    
    
    1,079,970
    
    
    
    5.7Other
    
    
    213,715
    
    
    
    0.8
    
    
    
    124,440
    
    
    
    0.74,135,697
    
    
    
    15.9
    
    
    
    3,580,893
    
    
    
    19.0Hybrid ARM assets:Remaining fixed period:3 years or less
    
    
    5,021,982
    
    
    
    19.3
    
    
    
    2,052,265
    
    
    
    10.9Over 3 years  5 years
    
    
    13,012,672
    
    
    
    50.0
    
    
    
    10,639,463
    
    
    
    56.4Over 5 years
    
    
    3,879,020
    
    
    
    14.8
    
    
    
    2,587,538
    
    
    
    13.721,913,674
    
    
    
    84.1
    
    
    
    15,279,266
    
    
    
    81.0Loan Loss Reserves
    
    
    (9,142
    )
    
    
    (0.0
    )
    
    
    (7,993
    )
    
    
    (0.0
    )$
    26,040,229
    
    
    
    100.0
    %
    
    $
    18,852,166
    
    
    
    100.0
    %
 The ARM portfolio had a weighted average coupon of 4.38% at September 30, 2004.
This consisted of a weighted average coupon of 4.45% on the hybrid portion of
the portfolio and a weighted average coupon of 3.41% on the rest of the
portfolio. If the portfolio had been fully indexed, the weighted average
coupon of the portfolio would have been 4.41%, based upon the composition of
the portfolio and the applicable indices at September 30, 2004. 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 3.86%,
also based upon the composition of the portfolio and the applicable indices at
September 30, 2004. 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. 40




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##### Table of Contents



At September 30, 2004, the current yield of the ARM assets portfolio was 4.00%,
down from 4.04% as of December 31, 2003. The decrease in the yield of 4 basis
points as of September 30, 2004, compared to December 31, 2003, is primarily
due to the higher level of net premium amortization, 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 both September 30, 2004 and December 31, 2003. The
Traditional ARM portion of the portfolio had a weighted average term to the
next repricing date of 80 days and the Hybrid ARM portion had a weighted
average term to the next repricing date of 4.3 years at September 30, 2004. As
of September 30, 2004, the Hybrid ARM portfolio comprised 84.1% 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 ARM 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 ARM Hedging Instruments that fix the interest rate on
those borrowings such that the net duration, which is the duration of borrowed
funds and Hybrid ARM Hedging Instruments minus the duration of Hybrid ARM
assets, is less than one year. 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 ARM 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 September 30, 2004, the net duration applicable to
our Hybrid ARM portfolio was approximately 2.9 months while the net duration
applicable to all of our ARM assets was approximately 2.6 months. As of September 30, 2004 and December 31, 2003, we were counterparty to Swap
Agreements and Eurodollar Transactions having an aggregate notional balance of
$18.6 billion and $12.5 billion, respectively. In addition, as of September
30, 2004, the Company had entered into delayed Swap Agreements with notional
balances totaling $1.5 billion that become effective in the fourth quarter of
2004. These delayed Swap Agreements have been entered into to hedge the
financing of our ARM asset purchase commitments at September 30, 2004. As of
September 30, 2004, these Swap Agreements and Eurodollar Transactions had a
weighted average maturity of 3.0 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 3.06% and 3.02% at September 30, 2004 and
December 31, 2003, respectively. As of September 30, 2004, ARM assets with a
carrying value of $73.6 million, including accrued interest, and cash totaling
$42.4 million collateralized the Swap Agreements. The net unrealized loss on
Swap Agreements at September 30, 2004 of $2.0 million included Swap Agreements
with gross unrealized losses of $67.0 million and gross unrealized gains of
$65.0 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 September 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 loss of $7.2 million.
We estimate that over the next twelve months, $32.7 million of these net
unrealized losses will be reclassified from Accumulated other comprehensive
income (loss) to interest expense. As of September 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 $1.3 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 September 30, 2004 and
December 31, 2003 was $16.9 million and $25.4 million, respectively, and is
included in Hedging instruments on the Consolidated Balance Sheets. As of
September 30, 2004, the unrealized loss on these Cap Agreements of $19.4
million is included in Accumulated other comprehensive income (loss). In the
twelve month period following September 30, 2004, $337.8 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 5.24%. The Cap Agreements had an
average maturity of 4.2 years as of September 30, 2004 and will expire between
2006 and 2013. 41




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##### Table of Contents



The following table presents the outstanding notional balance of our Hybrid ARM
Hedging Instruments as of September 30, 2004 and the balance of these same
Hybrid ARM Hedging Instruments as of September 30 for each of the following
five years, without any assumption that additional Hybrid ARM Hedging
Instruments are added to the portfolio in the future periods (amounts in
thousands): As of September 30,2004
    
    2005
    
    2006
    
    2007
    
    2008
    
    2009Swap Agreements:Balance-guaranteed (1) (3)
    
    $
    2,001,502
    
    
    $
    1,601,202
    
    
    $
    1,301,709
    
    
    $
    802,828
    
    
    $
    451,031
    
    
    $
    140,235Other (2)
    
    
    16,152,228
    
    
    
    12,180,825
    
    
    
    6,721,850
    
    
    
    2,255,023
    
    
    
    891,126
    
    
    
    477,00818,153,730
    
    
    
    13,782,027
    
    
    
    8,023,559
    
    
    
    3,057,881
    
    
    
    1,342,157
    
    
    
    617,243Eurodollar Transactions (2)
    
    
    414,000
    
    
    
    336,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Cap Agreements (1) (3)
    
    
    1,301,573
    
    
    
    1,041,258
    
    
    
    809,429
    
    
    
    524,224
    
    
    
    342,007
    
    
    
    77,340$
    19,869,303
    
    
    $
    15,129,285
    
    
    $
    8,832,988
    
    
    $
    3,582,105
    
    
    $
    1,684,164
    
    
    $
    694,583
  (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 2014(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 ARM Hedging Instruments as of September 30,
2004 and as of September 30 for each of the following five years (in
thousands): As of September 30,2004
    
    2005
    
    2006
    
    2007
    
    2008
    
    2009Swap Agreements
    
    $
    2,001,502
    
    
    $
    1,743,801
    
    
    $
    1,479,638
    
    
    $
    932,012
    
    
    $
    529,537
    
    
    $
    168,777Cap Agreements
    
    
    1,301,573
    
    
    
    1,194,506
    
    
    
    927,999
    
    
    
    753,915
    
    
    
    474,115
    
    
    
    323,054$
    3,303,075
    
    
    $
    2,938,307
    
    
    $
    2,407,637
    
    
    $
    1,685,927
    
    
    $
    1,003,652
    
    
    $
    491,831
 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, in the past we 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. We have discontinued the
policy of specifically hedging the maximum lifetime interest rate cap on
Traditional ARM assets because our duration management strategies incorporate
these potential life cap risks. As of September 30, 2004, our Traditional ARM
assets had an average lifetime interest rate cap of 10.38%, far exceeding the
current level of interest rates. At September 30, 2004, these Cap Agreements
had a remaining notional balance of $200.0 million with an average final
maturity of 3.2 months, compared to a remaining notional balance of $841.3
million with an average final maturity of 8 months at December 31, 2003. At
September 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 8.25% and average approximately 8.13%. 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 42




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##### Table of Contents



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. The fair value of the Pipeline Hedging Instruments at September 30, 2004 and
December 31, 2003 was a net unrealized loss of $5.1 million and a net
unrealized gain of $953.4 thousand, respectively, and is included in Hedging
instruments on the Consolidated Balance Sheets. Pipeline Hedging Instruments
had remaining notional balances of $357.0 million and $283.0 million at
September 30, 2004 and December 31, 2003, respectively. The net loss of $1.8
million on Pipeline Hedging Instruments for the nine months ended September 30,
2004 is reflected in Gain (loss) on ARM assets and hedging instruments, net on
the Consolidated Income Statements as is the $3.8 million loss on purchase loan
commitments for the nine months ended September 30, 2004. Asset Acquisitions During the quarter ended September 30, 2004, we purchased $4.3 billion of ARM
securities, 99.7% of which were High Quality assets and $1.2 billion of ARM
loans, generally originated to A quality underwriting standards. Of the ARM
assets acquired during the third quarter of 2004, 91.8% were Hybrid ARM assets
and 8.2% were Traditional ARM assets generally indexed to LIBOR. The following
table compares our ARM asset acquisition and origination activity for the
three- and nine-month periods ended September 30, 2004 and 2003 (dollar amounts
in thousands): For the three months ended:
    
    For the nine months ended:September 30,
    
    September 30,
    
    September 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003ARM securities:Agency Securities
    
    $
    
    
    
    $
    
    
    
    $
    1,054,570
    
    
    $
    348,211High Quality, non-Agency
    
    
    4,297,412
    
    
    
    2,631,050
    
    
    
    9,757,467
    
    
    
    7,026,579Other non-Agency
    
    
    11,585
    
    
    
    8,477
    
    
    
    29,795
    
    
    
    26,0634,308,997
    
    
    
    2,639,527
    
    
    
    10,841,832
    
    
    
    7,400,853ARM loans:Bulk acquisitions
    
    
    
    
    
    
    608,150
    
    
    
    88,959
    
    
    
    1,281,669Correspondent originations
    
    
    1,069,584
    
    
    
    778,299
    
    
    
    2,873,507
    
    
    
    2,246,728Direct retail originations
    
    
    106,861
    
    
    
    221,045
    
    
    
    341,678
    
    
    
    431,9211,176,445
    
    
    
    1,607,494
    
    
    
    3,304,144
    
    
    
    3,960,318Total acquisitions
    
    $
    5,485,442
    
    
    $
    4,247,021
    
    
    $
    14,145,976
    
    
    $
    11,361,171
 As of September 30, 2004, we had commitments to purchase $1.9 billion of ARM
securities and $730.0 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 September 29, 2004, we completed a CDO transaction in which we securitized
$1.3 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 separate bankruptcy-remote legal
entity, on a consolidated basis: (i) we did not account for this
securitization as a sale and (ii) we retained $39.5 million of subordinated
classes, of which $30.1 million were Investment Grade and $9.4 million were
below Investment Grade, to provide credit support to the securitization. Of
the loans that we securitized during the third quarter of 2004, 99.2% of our
resulting investment was rated at least Investment Grade and 0.8% of our
investment was rated below Investment Grade. In connection with the issuance
of these CDOs, we incurred costs of $4.0 million, which were deducted from the
proceeds of the transaction and are being amortized over the expected life of
the CDOs. All discussions 43




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##### Table of Contents



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 September 30, 2004, our mortgage assets paid down at an
approximate average annualized Constant Prepayment Rate (CPR) of 23%,
compared to 35% for the quarter ended June 30, 2004 and 39% for the quarter
ended September 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 September 30, 2004, we had unencumbered
assets of $874.9 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, asset-backed commercial paper, the issuance of
CDOs and whole loan financing facilities, as well as principal and interest
payments from ARM assets. The reverse repurchase agreement market is a $4
trillion market, the asset-backed commercial paper market is a $1.4 trillion
market and the AAA-rated mortgage- and asset- backed securities market is a $10
trillion market, all of which have been readily available sources of financing
for mortgage assets, particularly those rated AA or better. Using AAA-rated
CDOs as 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 September 30, 2004 consisted
of reverse repurchase agreements, asset-backed commercial paper, 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 remain the
same. We have arrangements to enter into reverse repurchase agreements with 24
different financial institutions and on September 30, 2004, had borrowed funds
from 18 of these firms. Reverse repurchase agreement borrowings outstanding at
September 30, 2004, had a weighted average effective cost of 1.89%. The
reverse repurchase agreements had a weighted average remaining term to maturity
of 2.6 months, although we utilize Swap Agreements and Eurodollar Transactions
to extend the re-pricing characteristic of total borrowings to 2.5 years. As
of September 30, 2004, $13.2 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, 0.6% 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 September 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. On June 30, 2004, we established a new $5 billion asset-backed commercial paper
facility, which provides an alternative way to finance our high quality ARM
securities portfolio. Through a wholly owned bankruptcyremote special purpose
subsidiary, we issue asset-backed commercial paper to investors in the form of
secured liquidity notes that are recorded as borrowings on our Consolidated
Balance Sheets and are rated P-1 by Moodys Investors Services and F1+ by Fitch
Ratings. 44




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##### Table of Contents



As of September 30, 2004, we had $3.2 billion of asset-backed commercial paper
outstanding with a weighted average interest rate of 1.85% and a weighted
average remaining maturity of 27 days. 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 September 30, 2004, the following CDOs
were outstanding (in thousands): Effective InterestDescription
    
    Principal Balance
    
    Rate (1)Floating-rate financing (2)
    
    $
    3,150,453
    
    
    
    2.28
    %Fixed-rate financing
    
    
    2,651,323
    
    
    
    4.05
    %Total
    
    $
    5,801,776
    
    
    
    3.09
    %
  (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
$1.3 billion and a weighted average strike price of 5.24% as of September
30, 2004. As of September 30, 2004, the CDOs were collateralized by ARM loans with a
principal balance of $5.8 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 September 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 November 2004 and March 2005. We expect to renew these
facilities in the ordinary course of business. As of September 30, 2004, we
had $297.5 million borrowed against these whole loan financing facilities at an
effective cost of 2.76%. 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,
asset-backed commercial paper and whole loan financing facilities. These forms
of borrowing are short-term in nature, mature on a frequent basis (weighted
average maturity of 2.4 months as of September 30, 2004), need to be rolled
over at each maturity and are subject to margin calls 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 margin requirements
typically average between 4% and 5% for these borrowings, so our policy
requires that we maintain capital of at least 8%, but we typically maintain 9%
to 10%, against the financing of these assets. We generally maintain a capital
cushion equal to approximately twice the margin requirement when using these
forms of borrowings. This capital 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 45




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##### Table of Contents



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 minimum 8% 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) September 30,
    
    December 31,2004
    
    2003Assets
    
    $
    26,445,728
    
    
    $
    19,118,799Adjustments:Net unrealized loss on ARM securities
    
    
    129,055
    
    
    
    42,717Net unrealized gain on hedging instruments
    
    
    (45,616
    )
    
    
    (8,655
    )ARM loans collateralizing CDOs
    
    
    (5,862,711
    )
    
    
    (3,146,961
    )Cap agreements
    
    
    (36,336
    )
    
    
    (31,692
    )Adjusted assets
    
    $
    20,630,120
    
    
    $
    15,974,208Shareholders equity
    
    $
    1,648,205
    
    
    $
    1,239,104Adjustments:Accumulated other comprehensive loss
    
    
    155,881
    
    
    
    142,778Equity supporting CDOs:CDOs
    
    
    5,801,776
    
    
    
    3,114,047ARM loans collateralizing CDOs
    
    
    (5,862,711
    )
    
    
    (3,146,961
    )Cap agreements
    
    
    (36,336
    )
    
    
    (31,692
    )(97,271
    )
    
    
    (64,606
    )Senior notes
    
    
    251,400
    
    
    
    251,080Adjusted shareholders equity
    
    $
    1,958,215
    
    
    $
    1,568,356Adjusted equity-to-assets ratio
    
    
    9.49
    %
    
    
    9.82
    %GAAP equity-to-assets ratio
    
    
    6.23
    %
    
    
    6.48
    %Ratio of historical equity-to-historical assets
    
    
    6.80
    %
    
    
    7.21
    %Ratio of historical equity plus Senior Notes
to historical assets
    
    
    7.75
    %
    
    
    8.53
    %Estimated total risk-based capital
/risk-weighted assets
    
    
    23.39
    %
    
    
    26.26
    %
 46




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##### Table of Contents



The above table also presents four 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 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 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 shareholders equity. The third 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
these ratios in order to have a complete picture of the relationship between
our total asset and long-term capital position. The fourth 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 September 30, 2004, we issued 1,796,210 shares of
common stock under the Dividend Reinvestment and Stock Purchase Plan (the
DRSPP) and received net proceeds of $49.9 million and we issued 2,303,600
shares of common stock through a controlled equity offering program and
received net proceeds of $64.2 million. Off-Balance Sheet Commitments As of September 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  agency
    
    $
    506,523ARM securities  private high quality
    
    
    1,363,552ARM securities  other
    
    
    14,590ARM loans  correspondent originations
    
    
    625,503ARM loans  direct originations
    
    
    104,459$
    2,614,627
 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. At September 30, 2004, the balance of the Hybrid
ARM securities was approximately $1.6 billion, but is expected to be less than
30% of that, and could be zero, at the time they convert into Traditional ARM
securities. At September 30, 2004, the balance of securities to be acquired in
2004 was approximately $15.0 million but may pay down to zero before the
purchase commitment date. If we decide not to acquire 47




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##### Table of Contents



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. Contractual Obligations As of September 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
    
    $
    15,093,315
    
    
    $
    15,093,315
    
    
    $
    
    
    
    $
    
    
    
    $
    Asset-backed commercial paper
    
    
    3,184,489
    
    
    
    3,184,489CDOs (1)
    
    
    5,801,776
    
    
    
    10,850
    
    
    
    25,073
    
    
    
    55,400
    
    
    
    5,710,453Whole loan financing facilities
    
    
    297,470
    
    
    
    297,470
    
    
    
    
    
    
    
    
    
    
    
    Senior Notes
    
    
    251,400
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    251,400Purchase commitments
    
    
    2,614,627
    
    
    
    2,614,627
    
    
    
    
    
    
    
    
    
    
    
    Total (2)
    
    $
    27,243,077
    
    
    $
    21,200,751
    
    
    $
    25,073
    
    
    $
    55,400
    
    
    $
    5,961,853
  (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. 48




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##### Table of Contents



Results of Operations For the Three Months Ended September 30, 2004 For the quarter ended September 30, 2004, our net income was $58.0 million, or
$0.69 basic and diluted earnings per share (EPS), based on a weighted average
of 84,643,000 shares outstanding. That compares to $45.8 million, or $0.69
basic EPS and $0.68 diluted EPS for the quarter ended September 30, 2003, based
on weighted average basic and diluted shares outstanding of 66,092,000 and
67,532,000, respectively, a 1.5% 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)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
    %Sep 30, 2004
    
    
    18.81
    %
    
    
    1.48
    %
    
    
    1.09
    %
    
    
    2.23
    %
    
    
    (1.16
    )%
    
    
    0.00
    %
    
    
    15.17
    %
   (1)
    
    General and administrative (G & A) expense excludes management and
performance fees and is net of servicing income.  (2)
    
    Other includes gain on ARM assets and hedging instruments, hedging
expense and provision for credit losses. Our return on equity declined slightly in the third quarter of 2004 compared to
the same period in 2003 primarily due to a decline in our portfolio margin
resulting from spread compression related to our Traditional ARM portfolio and
an increase in our hedging position to reduce our exposure to rising interest
rates on our Hybrid ARM portfolio. This decline was partially offset by the
sale of ARM securities during the third quarter of 2004. 49




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##### Table of Contents



The following table presents the components of our net interest income for the
quarters ended September 30, 2004 and 2003: Comparative Net Interest Income Components
(in thousands) For the quarters ended September 30,2004
    
    2003Coupon interest income on ARM assets
    
    $
    253,834
    
    
    $
    160,166Amortization of net premium
    
    
    (14,392
    )
    
    
    (10,024
    )Cash and cash equivalents
    
    
    609
    
    
    
    1,024Interest income
    
    
    240,051
    
    
    
    151,166Reverse repurchase agreements and
asset-backed commercial paper
    
    
    69,558
    
    
    
    36,137CDOs
    
    
    25,482
    
    
    
    5,398Whole loan financing facilities
    
    
    5,348
    
    
    
    4,688Senior notes
    
    
    5,237
    
    
    
    4,180Hedging instruments
    
    
    62,473
    
    
    
    40,858Interest expense
    
    
    168,098
    
    
    
    91,261Net interest income
    
    $
    71,953
    
    
    $
    59,905
 As presented in the table above, our net interest income increased by $12.0
million in the third quarter of 2004 compared to the third quarter of 2003.
The change was attributable to a $88.9 million increase in interest income
primarily due to an increased asset base, partially offset by a $76.8 million
increase in interest expense. Interest expense increased by $33.4 million due
to increased reverse repurchase agreements and asset-backed commercial paper
outstanding along with increased borrowing rates and $21.6 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 $21.9 billion and $13.3 billion at September 30, 2004 and 2003,
respectively. Interest expense increased by $20.1 million due to our issuance
of additional CDOs. The balance of our CDOs increased to $5.8 billion at
September 30, 2004 from $2.2 billion at September 30, 2003. 50




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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 September 30,2004
    
    2003Interest
    
    
    
    
    
    
    
    
    
    InterestAverage
    
    Effective
    
    Income and
    
    Average
    
    Effective
    
    Income andBalance
    
    Rate
    
    Expense
    
    Balance
    
    Rate
    
    ExpenseInterest-Earning Assets:ARM assets
    
    $
    24,201,337
    
    
    
    3.96
    %
    
    $
    239,442
    
    
    $
    15,287,022
    
    
    
    3.93
    %
    
    $
    150,142Cash and cash equivalents
    
    
    248,749
    
    
    
    0.98
    
    
    
    609
    
    
    
    414,113
    
    
    
    0.99
    
    
    
    1,02424,450,086
    
    
    
    3.93
    
    
    
    240,051
    
    
    
    15,701,135
    
    
    
    3.85
    
    
    
    151,166Interest-Bearing Liabilities:Reverse repurchase agreements and
asset-backed commercial paper
    
    
    17,009,274
    
    
    
    1.64
    
    
    
    69,558
    
    
    
    11,868,573
    
    
    
    1.22
    
    
    
    36,137Plus: Cost of Hedging instruments (1)
    
    
    
    
    
    
    1.30
    
    
    
    55,407
    
    
    
    
    
    
    
    1.38
    
    
    
    40,858Hedged reverse repurchase agreements
    
    
    
    
    
    
    2.94
    
    
    
    124,965
    
    
    
    
    
    
    
    2.59
    
    
    
    76,995CDOs
    
    
    4,761,618
    
    
    
    2.14
    
    
    
    25,482
    
    
    
    1,407,620
    
    
    
    1.53
    
    
    
    5,398Plus: Cost of Hedging instruments (1)
    
    
    
    
    
    
    0.59
    
    
    
    7,066
    
    
    
    
    
    
    
    0.00
    
    
    
    Hedged CDOs
    
    
    
    
    
    
    2.73
    
    
    
    32,548
    
    
    
    
    
    
    
    1.53
    
    
    
    5,398Whole loan financing facilities
    
    
    921,853
    
    
    
    2.32
    
    
    
    5,348
    
    
    
    976,095
    
    
    
    1.92
    
    
    
    4,688Senior Notes
    
    
    251,310
    
    
    
    8.34
    
    
    
    5,237
    
    
    
    194,402
    
    
    
    8.60
    
    
    
    4,18022,944,055
    
    
    
    2.93
    
    
    
    168,098
    
    
    
    14,446,690
    
    
    
    2.53
    
    
    
    91,261Net Interest-Earning Assets
and Spread
    
    $
    1,506,031
    
    
    
    1.00
    %
    
    $
    71,953
    
    
    $
    1,254,445
    
    
    
    1.32
    %
    
    $
    59,905Yield on Net Interest-Earning Assets (2)
    
    
    
    
    
    
    1.18
    %
    
    
    
    
    
    
    
    
    
    
    1.53
    %
  (1)
    
    Includes Swap Agreements and Eurodollar Transactions with notional
balances of $18.6 billion and $9.6 billion as of September 30, 2004 and
2003, respectively, and Cap Agreements with notional balances of $1.3
billion and $1.5 billion as of September 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. 51




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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 September 30,2004 versus 2003Rate
    
    Volume
    
    TotalInterest Income:ARM assets
    
    $
    1,104
    
    
    $
    88,196
    
    
    $
    89,300Cash and cash equivalents
    
    
    (10
    )
    
    
    (405
    )
    
    
    (415
    )1,094
    
    
    
    87,791
    
    
    
    88,885Interest Expense:Reverse repurchase agreements
and asset-backed commercial
paper
    
    
    10,201
    
    
    
    37,769
    
    
    
    47,970CDOs
    
    
    4,223
    
    
    
    22,927
    
    
    
    27,150Whole loan financing facilities
    
    
    975
    
    
    
    (315
    )
    
    
    660Senior Notes
    
    
    (129
    )
    
    
    1,186
    
    
    
    1,05715,270
    
    
    
    61,567
    
    
    
    76,837Net interest income
    
    $
    (14,176
    )
    
    $
    26,224
    
    
    $
    12,048
 As presented in the table above, net interest income increased by $12.0
million. This increase in net interest income is composed of a favorable
volume variance, partially offset by an unfavorable rate variance. The
increased average size of our portfolio during the third quarter of 2004
compared to the same period of 2003 increased net interest income in the amount
of $26.2 million. The average balance of our interest-earning assets was $24.5
billion during the quarter ended September 30, 2004, compared to $15.7 billion
during the same period of 2003  an increase of 56.1%. As a result of our
cost of funds increasing to 2.93% during the third quarter of 2004 from 2.53%
during the same period of 2003, an increase of 40 basis points, while the yield
on our interest-earning assets increased to 3.93% from 3.85% during the same
time period, an increase of 8 basis points, there was a net unfavorable rate
variance of $14.2 million. This was primarily due to an unfavorable rate
variance on borrowings in the amount of $15.3 million partially offset by a
favorable rate variance on our ARM assets portfolio and other interest-earning
assets that increased net interest income by $1.1 million. 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
    
    AssetsSep 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
    %Sep 30, 2004
    
    $
    24,450
    
    
    
    4.30
    %
    
    
    0.37
    %
    
    
    3.93
    %
    
    
    2.93
    %
    
    
    1.00
    %
    
    
    1.18
    %
  (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.  (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. 52




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##### Table of Contents



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)
    
    AdjustmentSep 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
    %Sep 30, 2004
    
    
    0.30
    %
    
    
    0.05
    %
    
    
    0.02
    %
    
    
    0.37
    %
  (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 third 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 September 30, 2003,
we recorded a $4.2 thousand increase in the fair value of our Life Cap Hedging
Instruments and reclassified to earnings $149.2 thousand of the transition
adjustment, for total hedging expense of $145.0 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 September 30,
2004, our whole loans, including those that we have securitized, but with
respect to which we have retained credit loss exposure, accounted for 36.2% of
our portfolio of ARM assets or $9.4 billion. During the quarter ended
September 30, 2004, we recorded loan loss provisions totaling $322.7 thousand
to reserve for estimated credit losses on loans. We recorded a net gain on ARM assets and hedging instruments of $4.9 million
during the third quarter of 2004. This gain consists of a $7.8 million gain on
the sale of $770.4 billion of ARM assets and a gain of $5.4 million on loans
purchased from correspondent lenders partially offset by an $8.3 million loss
on Eurodollar Transactions hedging the loan commitment pipeline. We realized a
$1.8 million net gain on ARM assets during the quarter ended September 30, 2003
primarily relating to the loan commitments pipeline. 53




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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 Management
    
    
    
    
    
    
    
    
    
    Total OperatingFor the
    
    Fee/
    
    Performance Fee/
    
    Other Expenses/
    
    Expenses/Quarter Ended
    
    Average Assets
    
    Average Assets
    
    Average Assets
    
    Average AssetsSep 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
    %Sep 30, 2004
    
    
    0.07
    %
    
    
    0.14
    %
    
    
    0.12
    %
    
    
    0.33
    %
 The most significant increases to our operating expenses for the quarter ended
September 30, 2004 compared to September 30, 2003 were the $1.4 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 $1.2 million increase
in the expenses associated with our Dividend Equivalent Rights (DERs) and
Phantom Stock Rights (PSRs), the $1.1 million increase in base management
fees and the $1.0 million increase in expenses related to expanded operations
of TMHL. Our return on equity prior to the effect of the performance-based fee
of $8.5 million for the third quarter of 2004 was 17.40%, whereas the
threshold, the average 10-year treasury rate plus 1%, was 5.30%. 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 (the Agreement),
payable monthly in arrears according to the following formula which was amended
in July 2004 and was 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 are 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. These percentages are
subject to adjustment each July based on changes to the Consumer Price Index
over the prior twelve month period. 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. 54




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##### Table of Contents



Results of Operations for the Nine Months Ended September 30, 2004 For the nine months ended September 30, 2004, our net income was $169.3
million, or $2.09 Basic and Diluted EPS, based on a weighted average of
80,896,000 shares outstanding. That compares to $127.0 million, or $2.04 Basic
EPS and $2.02 Diluted EPS, for the same period in 2003, based on a weighted
average of 60,572,000 and 62,887,000 shares outstanding, respectively, a 3.5%
increase in our Diluted earnings per share. Our return on average common equity was 15.68% for the nine months ended
September 30, 2004 compared to 17.55% for the nine months ended September 30,
2003. The following table presents the components of our net interest income: Comparative Net Interest Income Components
(Dollar amounts in thousands) For the nine months ended September 30,2004
    
    2003Coupon interest income on ARM assets
    
    $
    688,408
    
    
    $
    434,481Amortization of net premium
    
    
    (36,912
    )
    
    
    (25,455
    )Cash and cash equivalents
    
    
    1,855
    
    
    
    2,233Interest income
    
    
    653,351
    
    
    
    411,259Reverse repurchase agreements and
asset-backed commercial paper
    
    
    162,863
    
    
    
    108,632CDOs
    
    
    56,073
    
    
    
    10,304Whole loan financing facilities
    
    
    12,194
    
    
    
    11,794Senior notes
    
    
    15,709
    
    
    
    6,270Hedging instruments
    
    
    190,787
    
    
    
    107,589Interest expense
    
    
    437,626
    
    
    
    244,589Net interest income
    
    $
    215,725
    
    
    $
    166,670
 As presented in the table above, our net interest income increased by $49.1
million in the nine months ended September 30, 2004 compared to the same period
of 2003. The change was attributable to a $242.1 million increase in interest
income primarily due to an increased asset base, partially offset by a $193.0
million increase in interest expense. Interest expense increased by $83.2
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 $21.9 billion and $13.3 billion at September
30, 2004 and 2003, respectively. Interest expense increased by $54.2 million
due to increased reverse repurchase agreements and asset-backed commercial
paper outstanding along with increased borrowing rates and $45.8 million due to
our issuance of additional CDOs and Senior Notes. The balance of our CDOs and
Senior Notes increased to $5.8 billion and $251.4 million, respectively, at
September 30, 2004 from $2.2 billion and $194.5 million, respectively, at
September 30, 2003. 55




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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 nine months ended September 30,2004
    
    2003Interest
    
    
    
    
    
    
    
    
    
    InterestAverage
    
    Effective
    
    Income and
    
    Average
    
    Effective
    
    Income andBalance
    
    Rate
    
    Expense
    
    Balance
    
    Rate
    
    ExpenseInterest-Earning Assets:ARM assets
    
    $
    22,058,190
    
    
    
    3.94
    %
    
    $
    651,496
    
    
    $
    13,049,508
    
    
    
    4.18
    %
    
    $
    409,026Cash and cash equivalents
    
    
    271,346
    
    
    
    0.91
    
    
    
    1,855
    
    
    
    263,606
    
    
    
    1.13
    
    
    
    2,23322,329,536
    
    
    
    3.90
    
    
    
    653,351
    
    
    
    13,313,114
    
    
    
    4.12
    
    
    
    411,259Interest-Bearing Liabilities:Reverse repurchase agreements and
asset-backed commercial paper
    
    
    15,834,532
    
    
    
    1.37
    
    
    
    162,863
    
    
    
    10,499,404
    
    
    
    1.38
    
    
    
    108,632Plus: Cost of Hedging instruments (1)
    
    
    
    
    
    
    1.47
    
    
    
    174,127
    
    
    
    
    
    
    
    1.37
    
    
    
    107,589Hedged reverse repurchase agreements
    
    
    
    
    
    
    2.84
    
    
    
    336,990
    
    
    
    
    
    
    
    2.75
    
    
    
    216,221CDOs
    
    
    3,952,446
    
    
    
    1.89
    
    
    
    56,073
    
    
    
    804,598
    
    
    
    1.71
    
    
    
    10,304Plus: Cost of Hedging instruments (1)
    
    
    
    
    
    
    0.56
    
    
    
    16,660
    
    
    
    
    
    
    
    0.00
    
    
    
    Hedged CDOs
    
    
    
    
    
    
    2.45
    
    
    
    72,733
    
    
    
    
    
    
    
    1.71
    
    
    
    10,304Whole loan financing facilities
    
    
    804,745
    
    
    
    2.02
    
    
    
    12,194
    
    
    
    781,211
    
    
    
    2.01
    
    
    
    11,794Senior notes
    
    
    251,194
    
    
    
    8.34
    
    
    
    15,709
    
    
    
    98,224
    
    
    
    8.51
    
    
    
    6,27020,842,917
    
    
    
    2.80
    
    
    
    437,626
    
    
    
    12,183,437
    
    
    
    2.68
    
    
    
    244,589Net Interest Earning-Assets
and Spread
    
    $
    1,486,619
    
    
    
    1.10
    %
    
    $
    215,725
    
    
    $
    1,129,677
    
    
    
    1.44
    %
    
    $
    166,670Yield on Net Interest-Earning Assets (2)
    
    
    
    
    
    
    1.29
    %
    
    
    
    
    
    
    
    
    
    
    1.67
    %
  (1)
    
    Includes Swap Agreements and Eurodollar Transactions with notional
balances of $18.6 billion and $9.6 billion as of September 30, 2004 and
2003, respectively, and Cap Agreements with notional balances of $1.3
billion and $1.5 billion as of September 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. 56




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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): Nine Months ended September 30,2004 versus 2003Rate
    
    Volume
    
    TotalInterest Income:ARM assets
    
    $
    (23,604
    )
    
    $
    266,074
    
    
    $
    242,470Cash and cash equivalents
    
    
    (431
    )
    
    
    53
    
    
    
    (378
    )(24,035
    )
    
    
    266,127
    
    
    
    242,092Interest Expense:Reverse repurchase agreements
and asset-backed commercial
paper
    
    
    7,226
    
    
    
    113,543
    
    
    
    120,769CDOs
    
    
    4,502
    
    
    
    57,927
    
    
    
    62,429Whole loan financing facilities
    
    
    43
    
    
    
    357
    
    
    
    400Senior notes
    
    
    (127
    )
    
    
    9,566
    
    
    
    9,43911,644
    
    
    
    181,393
    
    
    
    193,037Net interest income
    
    $
    (35,679
    )
    
    $
    84,734
    
    
    $
    49,055
 As presented in the table above, net interest income increased by $49.1
million. This increase in net interest income is composed of a favorable
volume variance, partially offset by an unfavorable rate variance. The
increased average size of our portfolio during the first nine months of 2004
compared to the same period of 2003 increased net interest income in the amount
of $84.7 million. The average balance of our interest-earning assets was $22.3
billion during the nine months ended September 30, 2004, compared to $13.3
billion during the same period of 2003  an increase of 67.7%. As a result of
the yield on our interest-earning assets decreasing to 3.90% during the first
nine months of 2004 from 4.12% during the same period of 2003, a decrease of 22
basis points, and our cost of funds increasing to 2.80% from 2.68% during the
same time period, an increase of 12 basis points, there was a net unfavorable
rate variance of $35.7 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 $24.0 million and an unfavorable rate variance
on borrowings in the amount of $11.6 million. For the nine months ended September 30, 2004, our ratio of operating expenses
to average assets was 0.33%, compared to 0.44% for the same period in 2003.
Our average assets increased from $13.3 billion in the first nine months of
2003 to $22.4 in the first nine months of 2004 while our operating expenses
increased from $43.9 million for the nine months ended September 30, 2003 to
$56.3 million for the nine months ended September 30, 2004. The most
significant single increase to our expenses was the $5.1 million increase in
the performance-based fee that the Manager earned during the first nine 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 18.03%,
whereas the threshold, the average 10-year treasury rate plus 1%, was 5.30%.
Our other expenses increased by approximately $7.3 million from the first nine
months of 2003 to the same period of 2004, primarily due to increased base
management fees, expenses of TMHLs operations and expenses associated with our
DERs and PSRs. The base management fee paid to the Manager increased by $3.5
million, TMHLs operations increased by $3.2 million, and our DERs and PSRs
expense increased by $637.6 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 57




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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, including purchase commitments, 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 September 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 September 30, 2004. The use of Hybrid ARM Hedging Instruments is a critical part of our interest
rate risk management strategies, and the effects of these Hybrid ARM 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 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
September 30, 2004 Base Case
    
    Parallel +100 bps
    
    Parallel +200 bps
    
    Parallel +300 bpsAssets:Traditional ARMs
    
    
    0.32
    Years
    
    
    0.41
    Years
    
    
    0.64
    Years
    
    
    0.86
    YearsHybrid ARMs
    
    
    2.05
    
    
    
    2.52
    
    
    
    2.88
    
    
    
    3.09Total ARM assets
    
    
    1.82
    
    
    
    2.23
    
    
    
    2.58
    
    
    
    2.79Borrowings and hedges
    
    
    (1.64
    )
    
    
    (1.78
    )
    
    
    (1.89
    )
    
    
    (1.96
    )Net portfolio duration
    
    
    0.22
    Years
    
    
    0.38
    Years
    
    
    0.52
    Years
    
    
    0.60
    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 8.0, 5.1 and 2.7 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. 58




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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 September 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 (0.6)%, (1.0)% and (3.2)%, respectively, of projected net
income for the twelve months ended September 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. 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 September 30, 2004, 10.7% 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, which is the duration of borrowed funds and Hybrid
ARM Hedging Instruments minus the duration of 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 59




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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. 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. Taxable income per share As a REIT, we pay substantially all of our taxable earnings in the form of
dividends to shareholders. Therefore, taxable income per share ,a non-GAAP
financial measurement, is a meaningful measurement for both management and
investors. A reconciliation of taxable income per common share to earnings per
share (basic) follows: Reconciliation of Taxable Income Per Share to Earnings Per Share Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Taxable income per share
    
    $
    0.74
    
    
    $
    0.69
    
    
    $
    2.24
    
    
    $
    2.06Additions:Hedging instruments, net
    
    
    0.01
    
    
    
    0.02
    
    
    
    0.12
    
    
    
    0.03Gain (loss) on purchase loan commitments
    
    
    
    
    
    
    0.03
    
    
    
    (0.12
    )
    
    
    0.03Payments under long-term incentive plan
    
    
    
    
    
    
    0.01
    
    
    
    0.01
    
    
    
    0.02Conversion of taxable REIT subsidiary
to qualified REIT subsidiary, net
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    0.01Deductions:Provision for credit losses, net
    
    
    
    
    
    
    (0.02
    )
    
    
    (0.01
    )
    
    
    0.01Long-term incentive plan expense
    
    
    (0.02
    )
    
    
    (0.04
    )
    
    
    (0.07
    )
    
    
    (0.12
    )Issuance of CDOs
    
    
    
    
    
    
    
    
    
    
    (0.03
    )
    
    
    Taxable REIT subsidiary income
    
    
    (0.04
    )
    
    
    
    
    
    
    (0.05
    )
    
    
    Earnings per share (basic)
    
    $
    0.69
    
    
    $
    0.69
    
    
    $
    2.09
    
    
    $
    2.04
 60




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Our 2003 tax return reported undistributed taxable income of $19.0 million, as
of December 31, 2003, which was distributed as part of our first quarter 2004
dividend on May 17, 2004. We estimate that our undistributed taxable income as
of September 30, 2004, after deducting the third quarter dividend declared on
October 19, 2004, was $32.0 million. 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 September 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 September 30, 2004, we believe that we
continued 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
September 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 September 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 September 30, 2004, there were no material pending legal proceedings
to which we were a party or of which any of our property was subject. 
 Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS Not applicable 
 Item 3. DEFAULTS UPON SENIOR SECURITIES Not applicable 
 Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None 
 Item 5. OTHER INFORMATION None 
 Item 6. EXHIBITS See Exhibit Index 61




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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: November 8, 2004
    /s/ Garrett ThornburgGarrett ThornburgChairman of the Board and Chief Executive Officer
(Principal Executive Officer) Dated: November 8, 2004
    /s/ Larry A. GoldstoneLarry A. GoldstonePresident and Chief Operating Officer
(authorized officer of registrant) Dated: November 8, 2004
    /s/ Richard P. StoryRichard P. StoryExecutive Vice President and Chief Financial Officer
(Principal Financial and Accounting Officer) 62




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Exhibit Index Exhibit Number
    
    Exhibit Description31.1
    
    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. 63