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UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 FORM 10-Q þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended: March 31, 2004 OR o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
 For the transition period from  to Commission File Number: 001-11914 THORNBURG MORTGAGE, INC.  Maryland
(State or other jurisdiction of
incorporation or organization)
    
    85-0404134
(IRS Employer
Identification Number)150 Washington Avenue
Santa Fe, New Mexico
(Address of principal executive offices)
    
    87501
(Zip Code)
 Registrants telephone number, including area code: (505) 989-1900 (Former name, former address and former fiscal year, if changed since last report)
Not applicable Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes x           No o 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 o 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) 81,134,145 as of May 3, 2004




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INDEX  
 PagePART I.
    
    FINANCIAL INFORMATIONItem 1.
    
    Financial StatementsConsolidated Balance Sheets at March 31, 2004 and December 31, 2003
    
    
    3Consolidated Income Statements for the three months ended
March 31, 2004 and March 31, 2003
    
    
    4Consolidated Statements of Comprehensive Income for the three months
ended March 31, 2004 and March 31, 2003
    
    
    5Consolidated Statement of Shareholders Equity for the three months
ended March 31, 2004 and March 31, 2003
    
    
    6Consolidated Statements of Cash Flows for the three months ended
March 31, 2004 and March 31, 2003
    
    
    7Notes to Consolidated Financial Statements
    
    
    8Item 2.
    
    Managements Discussion and Analysis of
Financial Condition and Results of Operations
    
    
    22Item 3.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    51Item 4.
    
    Controls and Procedures
    
    
    51PART II.
    
    OTHER INFORMATIONItem 1.
    
    Legal Proceedings
    
    
    52Item 2.
    
    Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
    
    
    52Item 3.
    
    Defaults Upon Senior Securities
    
    
    52Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    52Item 5.
    
    Other Information
    
    
    52Item 6.
    
    Exhibits and Reports on Form 8-K
    
    
    52SIGNATURES
    
    
    53EXHIBIT INDEX
    
    
    54Amendment to 2002 Long-Term Incentive PlanCertification-Chief Executive OfficerCertification-President & Chief Operating OfficerCertification-VP & Chief Financial OfficerCertification-Chief Executive OfficerCertification-President & Chief Operating OfficerCertification-VP & Chief Financial Officer
  2




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PART I. FINANCIAL INFORMATION 
 Item 1. FINANCIAL STATEMENTS THORNBURG MORTGAGE, INC. AND SUBSIDIARIES 
 CONSOLIDATED BALANCE SHEETS (unaudited)
  ASSETS
    
    March 31, 2004
    
    December 31, 2003Adjustable-rate mortgage (ARM) assets:ARM securities, net
    
    $
    13,791,972
    
    
    $
    11,520,741ARM loans:Securitized ARM loans, net
    
    
    3,530,532
    
    
    
    3,687,466ARM loans collateralizing debt obligations, net
    
    
    4,145,507
    
    
    
    3,146,961ARM loans held for securitization, net
    
    
    397,397
    
    
    
    496,998ARM loans
    
    
    8,073,436
    
    
    
    7,331,425ARM assets
    
    
    21,865,408
    
    
    
    18,852,166Cash and cash equivalents
    
    
    303,446
    
    
    
    85,366Restricted cash
    
    
    123,046
    
    
    
    51,600Hedging instruments
    
    
    18,738
    
    
    
    40,356Accrued interest receivable
    
    
    82,093
    
    
    
    73,702Prepaid expenses and other
    
    
    17,190
    
    
    
    15,609$
    22,409,921
    
    
    $
    19,118,799LIABILITIESReverse repurchase agreements
    
    $
    16,246,508
    
    
    $
    13,926,858Collateralized debt obligations (CDOs)
    
    
    4,103,399
    
    
    
    3,114,047Whole loan financing facilities
    
    
    105,905
    
    
    
    369,343Hedging instruments
    
    
    208,478
    
    
    
    113,518Senior notes
    
    
    251,127
    
    
    
    251,080Accrued interest payable
    
    
    30,717
    
    
    
    26,114Dividends payable
    
    
    
    
    
    
    47,350Accrued expenses and other
    
    
    34,920
    
    
    
    31,38520,981,054
    
    
    
    17,879,695COMMITMENTSSHAREHOLDERS EQUITYCommon stock: par value $.01 per share;
499,978 shares authorized,
80,035 and 73,985 shares issued
and outstanding, respectively
    
    
    800
    
    
    
    740Additional paid-in-capital
    
    
    1,545,150
    
    
    
    1,376,879Accumulated other comprehensive loss
    
    
    (174,709
    )
    
    
    (142,778
    )Retained earnings
    
    
    57,626
    
    
    
    4,2631,428,867
    
    
    
    1,239,104$
    22,409,921
    
    
    $
    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 EndedMarch 31,2004
    
    2003Interest income from ARM assets and cash equivalents
    
    $
    195,813
    
    
    $
    123,196Interest expense on borrowed funds
    
    
    (126,093
    )
    
    
    (71,162
    )Net interest income
    
    
    69,720
    
    
    
    52,034Fee income
    
    
    822
    
    
    
    304Gain on ARM assets, net
    
    
    3,544
    
    
    
    Hedging expense
    
    
    (158
    )
    
    
    (177
    )Provision for credit losses
    
    
    (432
    )
    
    
    Management fee
    
    
    (3,627
    )
    
    
    (2,485
    )Performance fee
    
    
    (8,334
    )
    
    
    (6,187
    )Long-term incentive awards
    
    
    (4,495
    )
    
    
    (1,669
    )Other operating expenses
    
    
    (3,677
    )
    
    
    (2,746
    )NET INCOME
    
    $
    53,363
    
    
    $
    39,074Net income
    
    $
    53,363
    
    
    $
    39,074Dividend on preferred stock
    
    
    
    
    
    
    (1,670
    )Net income available to common shareholders
    
    $
    53,363
    
    
    $
    37,404Basic earnings per share:Net income
    
    $
    0.70
    
    
    $
    0.67Average number of shares outstanding
    
    
    76,631
    
    
    
    55,631Diluted earnings per share:Net income
    
    $
    0.70
    
    
    $
    0.67Average number of shares outstanding
    
    
    76,631
    
    
    
    58,391
 See Notes to Consolidated Financial Statements. 4




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THORNBURG MORTGAGE, INC. AND SUBSIDIARIES 
 CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)  Three Months EndedMarch 31,2004
    
    2003Net income
    
    $
    53,363
    
    
    $
    39,074Other comprehensive income:Unrealized gains on securities:Net unrealized holdings gains arising during the period
    
    
    87,054
    
    
    
    3,850Reclassification adjustment for net (gains) losses included in income
    
    
    (3,012
    )Net change in unrealized gains on securities
    
    
    84,042
    
    
    
    3,850Unrealized
losses on hybrid hedging instruments:Net unrealized losses arising during the period
    
    
    (177,452
    )
    
    
    (35,689
    )Reclassification adjustment for net losses included in income
    
    
    61,479
    
    
    
    31,280Net change
in unrealized losses on hybrid hedging instruments
    
    
    (115,973
    )
    
    
    (4,409
    )Other comprehensive income
    
    $
    21,432
    
    
    $
    38,515
 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
    
    RetainedStock
    
    Stock
    
    Paid-in Capital
    
    Income (Loss)
    
    Stock Sales
    
    Earnings
    
    TotalBalance, December 31, 2002
    
    $
    65,805
    
    
    $
    528
    
    
    $
    878,929
    
    
    $
    (105,254
    )
    
    $
    (7,437
    )
    
    $
    471
    
    
    $
    833,042Comprehensive income:Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    39,074
    
    
    
    39,074Other comprehensive income:Available-for-sale assets:Fair value adjustment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,850
    
    
    
    
    
    
    
    
    
    
    
    3,850Hedging instruments:Fair value adjustment, net of
amortization
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (4,409
    )
    
    
    
    
    
    
    
    
    
    
    (4,409
    )Issuance of common stock
    
    
    
    
    
    
    63
    
    
    
    122,090
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    122,153Interest and principal payments on
notes receivable from stock sales
    
    
    
    
    
    
    
    
    
    
    71
    
    
    
    
    
    
    
    100
    
    
    
    
    
    
    
    171Dividends declared on preferred
stock  $0.605 per share
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,670
    )
    
    
    (1,670
    )Balance, March 31, 2003
    
    $
    65,805
    
    
    $
    591
    
    
    $
    1,001,090
    
    
    $
    (105,813
    )
    
    $
    (7,337
    )
    
    $
    37,875
    
    
    $
    992,211Balance, December 31, 2003
    
    $
    
    
    
    $
    740
    
    
    $
    1,376,879
    
    
    $
    (142,778
    )
    
    $
    
    
    
    $
    4,263
    
    
    $
    1,239,104Comprehensive income:Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    53,363
    
    
    
    53,363Other comprehensive income:Available-for-sale assets:Fair value adjustment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    84,042
    
    
    
    
    
    
    
    
    
    
    
    84,042Hedging instruments:Fair value adjustment, net of
amortization
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (115,973
    )
    
    
    
    
    
    
    
    
    
    
    (115,973
    )Issuance of common stock
    
    
    
    
    
    
    60
    
    
    
    168,271
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    168,331Balance, March 31, 2004
    
    $
    
    
    
    $
    800
    
    
    $
    1,545,150
    
    
    $
    (174,709
    )
    
    $
    
    
    
    $
    57,626
    
    
    $
    1,428,867
 See Notes to Consolidated Financial Statements. 6




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THORNBURG MORTGAGE, INC. AND SUBSIDIARIES 
 CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
  Three Months EndedMarch 31,2004
    
    2003Operating Activities:Net income
    
    $
    53,363
    
    
    $
    39,074Adjustments to reconcile net income to net cash provided
by operating activities:Amortization
    
    
    12,721
    
    
    
    8,167Gain on ARM assets, net
    
    
    (3,544
    )
    
    
    Provision for credit losses
    
    
    432
    
    
    
    Hedging expense
    
    
    158
    
    
    
    177Change in assets and liabilities:Accrued interest receivable
    
    
    (8,391
    )
    
    
    (5,551
    )Prepaid expenses and other
    
    
    (4,573
    )
    
    
    2,177Accrued interest payable
    
    
    4,603
    
    
    
    1,662Accrued expenses and other
    
    
    3,535
    
    
    
    3,757Net cash provided by operating activities
    
    
    58,304
    
    
    
    49,463Investing Activities:ARM securities:Purchases
    
    
    (3,563,852
    )
    
    
    (1,847,351
    )Proceeds on sales
    
    
    348,709
    
    
    
    Principal payments
    
    
    1,021,834
    
    
    
    852,898Securitized ARM loans:Issuance costs
    
    
    
    
    
    
    (1,033
    )Principal payments
    
    
    129,469
    
    
    
    285,310ARM loans collateralizing debt obligations:Principal payments
    
    
    116,796
    
    
    
    24,855ARM loans held for securitization:Purchases and originations
    
    
    (997,871
    )
    
    
    (1,204,489
    )Principal payments
    
    
    11,846
    
    
    
    9,403Net cash used in investing activities
    
    
    (2,933,069
    )
    
    
    (1,880,407
    )Financing Activities:Net borrowings from reverse repurchase agreements
    
    
    2,319,650
    
    
    
    1,715,413Net borrowings of CDOs
    
    
    989,352
    
    
    
    (255,415
    )Net whole loan financing facilities (paydowns) borrowings
    
    
    (263,438
    )
    
    
    473,156Payments made on Eurodollar contracts
    
    
    (2,254
    )
    
    
    (5,579
    )Proceeds from common stock issued, net
    
    
    168,331
    
    
    
    122,153Dividends paid
    
    
    (47,350
    )
    
    
    (32,536
    )Payments on notes receivable from stock sales
    
    
    
    
    
    
    171Net increase in restricted cash
    
    
    (71,446
    )
    
    
    (15,782
    )Net cash provided by financing activities
    
    
    3,092,845
    
    
    
    2,001,581Net increase in cash and cash equivalents
    
    
    218,080
    
    
    
    170,637Cash and cash equivalents at beginning of period
    
    
    85,366
    
    
    
    47,818Cash and cash equivalents at end of period
    
    $
    303,446
    
    
    $
    218,455
 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 March 31, 2004 are not
necessarily indicative of the results that may be expected for the calendar
year ending December 31, 2004. The interim financial information should be
read in conjunction with Thornburg Mortgage, Inc.s 2003 Annual Report on Form
10-K/A. Basis of presentation and principles of consolidation The consolidated financial statements include the accounts of Thornburg
Mortgage, Inc. (together with its subsidiaries referred to hereafter as
the Company) and its wholly owned bankruptcy-remote special purpose
finance subsidiaries, Thornburg Mortgage Funding Corporation (TMFC) and
Thornburg Mortgage Acceptance Corporation (TMAC), its wholly owned
mortgage loan origination subsidiary, Thornburg Mortgage Home Loans, Inc.
(TMHL), and TMHLs two wholly owned special purpose finance
subsidiaries, Thornburg Mortgage Funding Corporation II and Thornburg
Mortgage Acceptance Corporation II. All of the Companys subsidiaries are
wholly owned qualified real estate investment trust (REIT) subsidiaries
and are consolidated with the Company for financial statement and tax
reporting purposes. 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 is intended to eliminate
the current diversity in practice that exists relating to the accounting
for loan commitments. SAB 105 is effective for loan commitments entered
into after March 31, 2003. Management believes that the Companys method
of accounting for loan commitments is consistent with the guidance
provided by SAB 105. Cash and cash equivalents Cash and cash equivalents includes cash on hand and highly liquid
investments with original maturities of three months or less. The
carrying amount of cash equivalents approximates their fair value. Restricted cash Restricted cash is primarily cash collateral held by counter-parties in
connection with reverse repurchase agreements and hedging instruments.
The carrying amount of restricted cash approximates its 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; also included in this balance are ARM securities relating to
loans securitized by the Company prior to April 1, 2001. 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 realized loss. Realized 8




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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 cost of the securities. ARM Loans are designated as held-for-investment as the Company has the
intent and ability to hold them for the foreseeable future, and until
maturity or payoff. ARM Loans are carried at their unpaid principal
balances, including unamortized premium or discount, unamortized loan
origination costs, unamortized deferred loan origination fees and
allowance for loan losses. Securitized ARM loans are loans originated or acquired by the Company and
securitized by the Company after March 31, 2001 with the Company retaining
100% of the beneficial ownership interests. ARM loans collateralizing long-term debt are loans the Company has
securitized that provide credit support for AAA certificates issued to
third party investors in structured financing arrangements. ARM loans held for securitization are loans the Company has acquired or
originated and are intended to be securitized and retained by the Company. The Company does not sell any of the securities created from its
securitizations to generate gain on sale income. The loan securitization
process benefits the Company by either creating highly liquid securitized
assets that can be readily financed in the reverse repurchase agreement
market or enabling the Company to enter into long-term collateralized debt
obligations (CDOs) which represent permanent financing that is not
subject to margin calls. 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. 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. Credit risk and allowance for loan losses The Company limits its exposure to credit losses on its portfolio of ARM
securities by purchasing ARM securities that have an Investment Grade
rating at the time of purchase and have some form of credit enhancement,
or are guaranteed by an agency of the federal government (Ginnie Mae) or
a government-sponsored or federally-chartered corporation (Fannie Mae or
Freddie Mac) (collectively Agency Securities). An Investment Grade
security generally has a security rating of BBB, Baa or better by at least
one of two nationally recognized rating agencies, Standard & Poors, Inc.
or Moodys Investors Service, Inc. (the Rating Agencies). Additionally,
the Company purchases and originates ARM loans or purchases all classes of
a third party ARM loan securitization (including the classes rated less
than Investment Grade). When the Company acquires classes of securities
that are below Investment Grade, the purchase price generally includes a
discount for probable credit losses; this reduction, or basis
adjustment, is recorded as part of the purchase price of that security.
In the event of impairment, the Company revises its estimate of probable
losses and any difference between the initial estimate and the new
estimate of losses is recorded in earnings. The Company limits its
exposure to credit losses by restricting its investment in Other
Investments to no more than 30% of total assets. Other Investments may
include, among other items, securities that are rated A or less by at
least one of the Rating Agencies at the time of purchase, including the
subordinate classes of securities retained as part of the Companys
securitization of loans or purchases of 100% of the classes from other
loan securitizations, and ARM loans held for securitization. The Company maintains an allowance for loan losses based on managements
estimate of credit losses inherent in the Companys portfolio of ARM
Loans. The estimation of the allowance is based on a variety of factors
including, but not limited to, current economic conditions, loan portfolio
composition, delinquency trends, credit losses to date on underlying loans
and remaining credit protection. If the credit performance of its ARM
Loans is different than expected, the Company adjusts the allowance for
loan losses to a level deemed appropriate by management to provide for
estimated losses inherent in its ARM Loan portfolio. Additionally, once a
loan is 90 days or more 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. 9




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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 certain dealers who make markets in these financial
instruments, or by third party pricing services. If the fair value of an
ARM security or securitized ARM loan is not reasonably available from a
dealer or a third party pricing service, management estimates the fair
value based on characteristics of the security that the Company receives
from the issuer and on available market information. The fair values of ARM loans held for securitization are estimated by the
Company by using the same pricing models employed by the Company in the
process of determining a price to bid for loans in the open market, taking
into consideration the aggregated characteristics of groups of loans such
as, but not limited to, collateral type, index, interest rate, margin,
length of fixed-rate period, life cap, periodic cap, underwriting
standards, age and credit. The net unrealized gain on commitments to purchase ARM loans from
correspondent lenders and bulk sellers is calculated using the same
methodologies that are used to value the Companys ARM Loans, adjusted for
anticipated fallout for interest rate lock commitments that will likely
not be funded. The Companys net unrealized gain (loss) on purchase loan
commitments is recorded as a component of ARM loans, net on the
Consolidated Balance Sheets with change in fair value recorded in Gain on
ARM assets on the Consolidated Income Statements. The fair values of the Companys CDOs, senior unsecured notes (Senior
Notes), interest rate swap agreements (Swap Agreements) and interest
rate cap agreements (Cap Agreements) are based on market values provided
by dealers who are familiar with the terms of the debt, Senior Notes, Swap
Agreements and Cap Agreements. The fair value of futures contracts 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, interest
receivable, reverse repurchase agreements, other borrowings and other
liabilities are reflected in the financial statements at their amortized
cost, which approximates their fair value because of the short-term nature
of these instruments. Hedging Instruments All of the Companys hedging instruments are derivative financial
instruments (Cap Agreements, Swap Agreements and Eurodollar futures
contracts) (collectively, Hedging Instruments) and are carried on the
Consolidated Balance Sheets at their fair value as an asset, if their fair
value is positive, or as a liability, if their fair value is negative. In
general, most of the Companys Hedging Instruments are designated as
cash flow hedges, and the effective amount of change in the fair value
of the derivative instrument is recorded in Accumulated other
comprehensive income (loss) and transferred to earnings as the hedged item
affects earnings. The ineffective amount of all Hedging Instruments is
recognized in earnings each quarter. Generally, a hedging strategy is
effective if it achieves offsetting cash flows attributable to the risk
being hedged, but if the hedging strategy is not successful in achieving
offsetting cash flows, it is ineffective. Certain Eurodollar futures
contracts (Eurodollar Transactions) have not been designated as cash
flow hedges since they are an economic hedge, hedging the fair value
change of the Companys purchase loan commitments. As such, the change in
their fair value is recorded in the Consolidated Income Statements as Gain
on ARM assets. 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. 10




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Hybrid Hedging Instruments The Company enters into Swap Agreements, Eurodollar Transactions and Cap
Agreements in order to manage its interest rate exposure when financing
its Hybrid ARM assets (collectively, Hybrid Hedging Instruments). The
Company generally borrows money based on short-term interest rates. The
Companys Hybrid ARM assets have an initial fixed interest rate period of
three to ten years. As a result, the Companys existing and forecasted
borrowings reprice to a new rate on a more frequent basis than do the
Companys Hybrid ARM assets. These Hybrid Hedging Instruments are used to
fix the interest rate on the Companys borrowings during the expected
fixed-rate period of the Companys Hybrid ARM assets such that the Company
maintains a duration on the borrowings and Hybrid Hedging Instruments that
closely matches the duration of the Companys Hybrid ARM assets. The
notional balances of the Hybrid Hedging Instruments generally decline over
the life of these instruments approximating the declining balance of the
Hybrid ARM assets being financed. Swap Agreements and Eurodollar Transactions have the effect of converting
the Companys variable-rate debt into fixed-rate debt over the life of the
Swap Agreements and Eurodollar Transactions. When the Company enters into
a Swap Agreement, it agrees to pay a fixed rate of interest and to receive
a variable interest rate, generally based on the London InterBank Offer
Rate (LIBOR). The Company also enters into Eurodollar Transactions in
order to fix the interest rate on its forecasted three-month LIBOR-based
liabilities. The Company also purchases Cap Agreements by incurring a one-time fee or
premium. Pursuant to the terms of the Cap Agreements, the Company will
receive cash payments if the interest rate index specified in any such Cap
Agreement increases above contractually specified levels. Therefore, such
Cap Agreements have the effect of capping the interest rate on a portion
of the Companys borrowings above a level specified by the Cap Agreement. The Company designates its Hybrid Hedging Instruments used to manage
interest rate exposure when financing its Hybrid ARM assets as cash flow
hedges. All changes in the unrealized gains and losses on Hybrid Hedging
Instruments have been recorded in Accumulated other comprehensive income
(loss) and are reclassified to earnings as interest expense when each of
the forecasted financing transactions occurs. If it becomes probable that
the forecasted transaction, which in this case refers to interest payments
to be made under the Companys short-term borrowing agreements, will not
occur by the end of the originally specified time period, as documented at
the inception of the hedging relationship, or within an additional
two-month time period thereafter, then the related gain or loss in
Accumulated other comprehensive income (loss) would be reclassified to
income. The carrying value of these Hybrid Hedging Instruments is
included in Hedging instruments on the Consolidated Balance Sheets. The unrealized gain/loss on Swap Agreements is based on the discounted
value of the remaining future net interest payments expected to be made
over the remaining life of the Swap Agreements. Therefore, over time, as
the actual payments are made, the unrealized gain/loss in Accumulated
other comprehensive income (loss) and the carrying value of the Swap
Agreements adjust to zero and the Company realizes a fixed cost of money
over the life of the Hedging Instrument. Life Cap Hedging Instruments The Company also purchases Cap Agreements to manage interest rate risk on
the financing of a portion of its Traditional ARM assets that have a
contractual maximum interest rate (Life Cap), which is a component of
the fair value of an ARM asset (Life Cap Hedging Instruments). 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 Instruments The 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 11




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##### Table of Contents



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 on ARM assets on the Consolidated
Income Statements as an offset to the net gain (loss) recorded for the
change in fair value of the loan commitments recorded pursuant to SFAS
149, Amendment of Statement 133 on Derivative Instruments and Hedging
Activities, issued by the Financial Accounting Standards Board in April
2003. 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 FAS 133. The net unrealized gain on the Companys ARM Loans of $92.5 million and
$7.9 million at March 31, 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 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. Net earnings per share Basic earnings per share (EPS) amounts are computed by dividing net
income (adjusted for dividends declared on preferred stock) by the
weighted average number of common shares outstanding. Diluted EPS amounts
assume the conversion, exercise or issuance of all potential common stock
instruments, unless the effect is to reduce a loss or increase the
earnings per common share. Following is information about the computation of the EPS data for the
three-month periods ended March 31, 2004 and 2003 (in thousands except per
share data): EarningsIncome
    
    Shares
    
    Per ShareThree Months Ended March 31, 2004Net income
    
    $
    53,363Basic and Diluted EPS, income available to
common shareholders
    
    
    53,363
    
    
    
    76,631
    
    
    $
    0.70Three Months Ended March 31, 2003Net income
    
    $
    39,074Less preferred stock dividends
    
    
    (1,670
    )Basic EPS, income available to common shareholders
    
    
    37,404
    
    
    
    55,631
    
    
    $
    0.67Effect of dilutive securities:Convertible preferred stock
    
    
    1,670
    
    
    
    2,760Diluted EPS
    
    $
    39,074
    
    
    
    58,391
    
    
    $
    0.67
 12




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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. Note 2. Adjustable-Rate Mortgage Assets The following tables present the Companys ARM assets as of March 31,
2004 and December 31, 2003 (in thousands): ARM loans
    
    ARM loansARM
    
    Securitized
    
    collateralizing
    
    held forMarch 31, 2004
    
    securities
    
    ARM loans
    
    CDOs
    
    securitization
    
    TotalPrincipal balance outstanding
    
    $
    13,523,042
    
    
    $
    3,511,129
    
    
    $
    4,123,642
    
    
    $
    392,518
    
    
    $
    21,550,331Net unamortized premium
    
    
    215,954
    
    
    
    22,675
    
    
    
    23,081
    
    
    
    4,174
    
    
    
    265,884Loan loss reserves
    
    
    
    
    
    
    (6,961
    )
    
    
    (1,216
    )
    
    
    (250
    )
    
    
    (8,427
    )Basis adjustments
    
    
    (3,397
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (3,397
    )Net unrealized gain on
purchase loan commitments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    955
    
    
    
    955Principal payment receivable
    
    
    15,198
    
    
    
    3,689
    
    
    
    
    
    
    
    
    
    
    
    18,887Amortized cost, net
    
    
    13,750,797
    
    
    
    3,530,532
    
    
    
    4,145,507
    
    
    
    397,397
    
    
    
    21,824,233Gross unrealized gains
    
    
    88,194
    
    
    
    36,221
    
    
    
    68,246
    
    
    
    1,289
    
    
    
    193,950Gross unrealized losses
    
    
    (47,019
    )
    
    
    (12,065
    )
    
    
    
    
    
    
    (1,200
    )
    
    
    (60,248
    )Fair value
    
    $
    13,791,972
    
    
    $
    3,554,688
    
    
    $
    4,213,753
    
    
    $
    397,486
    
    
    $
    21,957,899Carrying value
    
    $
    13,791,972
    
    
    $
    3,530,532
    
    
    $
    4,145,507
    
    
    $
    397,397
    
    
    $
    21,865,408
 ARM loans
    
    ARM loansARM
    
    Securitized
    
    collateralizing
    
    held forDecember 31, 2003
    
    securities
    
    ARM loans
    
    CDOs
    
    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 of $3.5 million during
the quarter ended March 31, 2004. This gain consists of a $3.2 million
gain on the sale of $345.5 million of ARM assets and a gain of $3.8
million on commitments to purchase loans from correspondent lenders and
bulk sellers, partially offset by a net loss of $3.5 million on
Eurodollar Transactions hedging the loan commitment pipeline. The
Company did not realize any gain or loss on ARM assets during the
quarter ended March 31, 2003. During the quarter ended March 31, 2004, the Company securitized $1.1
billion of its ARM loans into a series of private-label multi-class ARM
securities, all of which were placed with third party investors,
thereby providing long-term collateralized financing for the Companys
assets, including over collateralization. The Company retained an
interest-only subordinate certificate that provides credit support to
the securitization. The Company did not account for this
securitization as a sale and, therefore, did not record any gain or
loss in 13




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##### Table of Contents



connection with the securitization. As of March 31, 2004, the Company
had $7.7 billion of ARM assets that have resulted from the Companys
securitization efforts. The Company does not purchase mortgage servicing rights (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 Fee income on the Consolidated
Income Statements, rather than being accounted for as interest income.
MSRs capitalized upon the securitization of $1.1 billion of ARM loans
during the quarter ended March 31, 2004 totaled $3.7 million. MSRs of
$11.5 million, net of amortization during the quarter ended March 31,
2004 of $852.3 thousand, are included in Prepaid Expenses and Other on
the Consolidated Balance Sheets at March 31, 2004. MSRs are carried at
the lower of cost or fair value and are periodically evaluated for
impairment using a discounted future cash flow model that considers
portfolio characteristics and assumptions regarding prepayments speed,
delinquency rates and other economic factors. For purposes of
evaluating and measuring impairment of MSRs, the Company stratifies its
portfolio on the basis of predominant risk characteristics, including
loan type (Traditional ARM or Hybrid ARM). At March 31, 2004, the fair
value of the MSRs in each risk stratum exceeded their cost basis. 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. As of March 31, 2004 and December 31, 2003, the Company had basis
adjustments of $3.4 million 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 $473.8 thousand related to
ARM securities purchased during the first quarter of 2004 on which the
Company had first loss credit exposure. These securities were
purchased as part of $587.6 million of third party loan securitizations
in which the Company purchased all classes of the securitizations,
including the subordinated classes. During the quarter ended March 31, 2004 the Company recorded loan loss
provisions totaling $432.4 thousand to reserve for estimated credit
losses on ARM Loans bringing its total loan loss reserve to $8.4
million. The Company has credit exposure on its ARM Loans. The following tables
summarize ARM Loan delinquency information as of March 31, 2004 and
December 31, 2003 (in thousands, except for loan count): March 31, 2004 PercentLoan
    
    Loan
    
    of ARM
    
    Percent ofDelinquency Status
    
    Count
    
    Balance
    
    Loans
    
    Total Assets60 to 89 days
    
    
    0
    
    
    $
    
    
    
    
    0.00
    %
    
    
    0.00
    %90 days or more
    
    
    0
    
    
    
    
    
    
    
    0.00
    
    
    
    0.00In bankruptcy and
foreclosure
    
    
    5
    
    
    
    1,231
    
    
    
    0.02
    
    
    
    0.015
    
    
    $
    1,231
    
    
    
    0.02
    %
    
    
    0.01
    %
 December 31, 2003 PercentLoan
    
    Loan
    
    of ARM
    
    Percent ofDelinquency Status
    
    Count
    
    Balance
    
    Loans
    
    Total 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
    %
 14




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##### Table of Contents



As of March 31, 2004, the Company had commitments to purchase or
originate the following amounts of ARM assets (in thousands): ARM securities  private high quality
    
    $
    1,290,621ARM securities  private other
    
    
    8,275ARM loans  correspondent originations
    
    
    605,943ARM loans  direct originations
    
    
    111,042$
    2,015,881
 The Company has entered into transactions whereby the Company expects
to acquire the remaining balance of certain AAA-rated Hybrid ARM
securities, at a price of par, between 2004 and 2008, when the
fixed-rate period of the Hybrid ARM securities terminates and the
securities convert into Traditional ARM securities with characteristics
similar to the Traditional ARM securities held in the current
portfolio. The Company views these transactions as an alternative
source of Traditional ARM assets. The current balance of the Hybrid
ARM securities is approximately $2.3 billion, but is expected to be
less than 25% of that, and could be zero, at the time they convert into
Traditional ARM securities. If the Company decides not to acquire the
Hybrid ARM securities when they convert into Traditional ARM
securities, then it is committed to pay or receive the difference
between par and the fair value of the Traditional ARM securities at
that time, as determined by an auction of the Traditional ARM
securities. The Company received a premium of $2.3 million related to
these transactions, which is being amortized over the declining balance
of the related securities. As of March 31, 2004, the Company had
delivered ARM assets with a carrying value of $6.7 million and $3.1
million in cash as collateral in connection with these transactions. Note 3. Hedging Instruments Hybrid Hedging Instruments As of March 31, 2004 and December 31, 2003, the Company was
counterparty to Swap Agreements and Eurodollar Transactions having
aggregate current notional balances of $14.4 billion and $12.5 billion,
respectively. In addition, as of March 31, 2004, the Company had
entered into two delayed Swap Agreements, one with a notional balance
of $509 million becoming effective in April 2004, and the second with a
notional balance of $180 million becoming effective in June 2004. As
of March 31, 2004, these Swap Agreements and Eurodollar Transactions
had a weighted average maturity of 3.6 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. As of March 31, 2004, ARM assets
with a carrying value of $124.8 million, including accrued interest,
and cash totaling $70.2 million collateralized the Swap Agreements and
Eurodollar Transactions. The net unrealized loss on Swap Agreements at March 31, 2004 of $186.3
million included Swap Agreements with gross unrealized gains of $2.7
million and gross unrealized losses of $189.0 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 March 31, 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 $199.8
million. The Company estimates that over the next twelve months, $87.3
million of these net unrealized losses will be reclassified from
Accumulated other comprehensive income (loss) to interest expense. As of March 31, 2004 and December 31, 2003, the Companys Cap
Agreements, used to manage its interest rate risk exposure on the
financing of the Hybrid ARM loans collateralizing the Companys CDOs,
had remaining notional amounts of $1.4 billion and $1.6 billion,
respectively. Included in these totals are Cap Agreements that have
start dates ranging from 2006 to 2008 and notional balances totaling
$371.1 million. The fair value of these Cap Agreements at March 31,
2004 and December 31, 2003 was $16.0 million and $25.4 million,
respectively, and is included in Hedging instruments on the
Consolidated Balance Sheets. As of March 31, 2004, the unrealized loss
on these Cap Agreements of $15.7 million is included in Accumulated
other comprehensive 15




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##### Table of Contents



income (loss). In the twelve month period following March 31, 2004,
$28.1 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 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 9.67% and average 3.81%.
The Cap Agreements had an average maturity of 4.9 years as of March
31, 2004 and will expire between 2006 and 2013. The Company hedges the funding of its Hybrid ARM assets such that the
weighted average net duration of borrowed funds, Hybrid Hedging
Instruments and Hybrid ARM assets is less than one year. At March 31,
2004, the financing and hedging of the Companys Hybrid ARM assets
resulted in a net duration of approximately 1.3 months while the
financing and hedging of all of the Companys ARM assets resulted in a
net duration of approximately 1.2 months. Interest expense for the quarters ended March 31, 2004 and 2003
includes net payments on Hybrid Hedging Instruments of $61.5 million
and $31.4 million, respectively. Life Cap Hedging Instruments The Life Cap Hedging Instruments had no fair value at March 31, 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.
Purchased Cap Agreements had a remaining notional amount of $838.1
million and $841.3 million as of March 31, 2004 and December 31, 2003,
respectively. The notional amount of the Life Cap Hedging Instruments
declines at a rate that is expected to approximate the amortization of
the Traditional ARM assets. The Company will receive cash payments
should the one-month or three-month LIBOR increase above the contract
rates of these Hedging Instruments, which range from 6.00% to 12.00%
and average 10.52%. The Life Cap Hedging Instruments had an average
final maturity of 5 months as of March 31, 2004 and expire between 2004
and 2005. During the quarters ended March 31, 2004 and 2003, the
Company recognized expenses of $158.1 thousand and $177.1 thousand,
respectively, which is reported as Hedging expense in the Companys
Consolidated Income Statements. Pipeline Hedging Instruments The fair value of the Pipeline Hedging Instruments at March 31, 2004
and December 31, 2003 was $4.3 million and $953.4 thousand,
respectively, and is included in Hedging instruments on the
Consolidated Balance Sheets. Pipeline Hedging Instruments had
remaining notional balances of $374.0 million and $283.0 million at
March 31, 2004 and December 31, 2003, respectively. During the quarter
ended March 31, 2004, the Company recognized a $3.5 million loss on
Pipeline Hedging Instruments, which is included in Gain on ARM assets
in the Companys Consolidated Income Statements and partially offsets
the $3.8 million gain recorded on loan commitments pursuant to SFAS
149. 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 March 31, 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 March 31, 2004, the Company had $16.2 billion of reverse
repurchase agreements outstanding with a weighted average borrowing
rate of 1.18% and a weighted average remaining maturity of 3.4 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 16




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##### Table of Contents



March 31, 2004, $15.7 billion of the Companys borrowings were
variable-rate term reverse repurchase agreements with original
maturities that range from three 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 $17.0 billion, including accrued interest, and
cash totaling $34.2 million, collateralized the reverse repurchase
agreements at March 31, 2004. Citigroup Inc. holds collateral with a
fair value, in excess of reverse repurchase borrowings with a weighted
average maturity of 4.6 months, of $198.4 million. At March 31, 2004, the reverse repurchase agreements had the following
remaining maturities (in thousands): Within 30 days
    
    $
    2,130,28131 to 89 days
    
    
    6,327,14490 to 365 days
    
    
    7,683,608Over 365 days
    
    
    105,475$
    16,246,508
 CDOs On March 31, 2004, $1.1 billion of ARM loans from the Companys ARM
loan portfolio were transferred to Thornburg Mortgage Securities Trust
2004-1 and were securitized. In this transaction, the Company issued
AAA and AA-rated floating-rate pass-through certificates totaling
$362.1 million and AAA and AA-rated fixed-rate pass-through
certificates totaling $741.0 million to third party investors. The
interest rates on the floating-rate pass-through certificates reset
monthly and are indexed to the one-month LIBOR rate. The interest
rates on the fixed-rate pass-through certificates are based on the
weighted average pass-through rate of the pool of underlying Hybrid ARM
loans which have initial fixed-rate terms ranging from three to ten
years and then convert to Traditional ARM loans. In connection with
the issuance of these CDOs, the Company incurred costs of $3.5 million,
which were deducted from the proceeds of the transaction and are being
amortized over the expected life of these CDOs. This transaction was
accounted for as a financing of the loans and represents permanent
financing that is not subject to margin calls. Based on the estimated
exposure to credit losses on the loans collateralizing the debt, the
structure of this transaction includes overcollateralization that
provides $2.8 million of initial credit support and, if needed,
additional credit support from excess cash flows over the life of a
subordinate certificate retained by the Company. All of the Companys CDOs were issued by trusts and are secured by its
ARM loans. For financial reporting and tax purposes, the trusts ARM
loans held as collateral are recorded as assets of the Company and the
CDOs are recorded as the Companys debt. In some transactions, Hedging
Instruments are held by the trusts and recorded as assets or
liabilities of the Company. The Hedging Instruments either fix the
interest rate of the pass-through certificates or cap the interest rate
exposure on these transactions. As of March 31, 2004, the following
CDOs were outstanding (in thousands): All-in InterestDescription
    
    Principal Balance
    
    Rate (1)Floating-rate financing (2)
    
    $
    2,564,396
    
    
    
    1.54
    %Fixed-rate financing
    
    
    1,539,003
    
    
    
    3.80
    %Total
    
    $
    4,103,399
    
    
    
    2.39
    %
  (1)
    
    All-in interest rate includes the impact of issuance
costs and Hedging Instruments.(2)
    
    Includes financing hedged with Cap Agreements with a
notional balance of $1.4 billion and a weighted average strike
price of 3.81% as of March 31, 2004. As of March 31, 2004, the CDOs were collateralized by ARM loans
with a principal balance of $4.1 billion. The debt matures between
2033 and 2044 and is callable by the Company at par once the total
balance of the 17




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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 March 31, 2004, the Company had entered into four whole loan
financing facilities. The interest rates on these facilities are
indexed to one-month LIBOR and reprice accordingly. These facilities
have a total committed borrowing capacity of $1.1 billion and an
uncommitted capacity of $500 million and expire between September 2004
and March 2005. The Company expects to renew these facilities. As of
March 31, 2004, the Company had $105.9 million borrowed against these
whole loan financing facilities at an effective cost of 2.88%. 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 March 31,
2004 was collateralized by ARM loans with a carrying value of $108.8
million, including accrued interest. These facilities have covenants
that are standard for industry practice; the Company was in compliance
with all such covenants at March 31, 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 works 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 On May 15, 2003, the Company issued $200.0 million in Senior Notes at
par. On December 2, 2003, the Company completed an add-on private
placement of $55.0 million of 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 March 31, 2004 and December 31,
2003, the balance of the Senior Notes outstanding, net of unamortized
issuance costs, was $251.1 million. As of March 31, 2004, all $255 million of the Senior Notes had been
exchanged for new registered Senior Notes with terms substantially
identical to the original Senior Notes, pursuant to exchange offers
concluded by the Company. 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 March 31, 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 $120.3 million and $68.9 million
for the quarters ended March 31, 2004 and 2003, respectively. 18




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##### Table of Contents



Contractual Obligations As of March 31, 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
    
    $
    16,246,508
    
    
    $
    16,141,033
    
    
    $
    105,475
    
    
    $
    
    
    
    $
    CDOs (1)
    
    
    4,103,399
    
    
    
    9,667
    
    
    
    21,499
    
    
    
    44,728
    
    
    
    4,027,505Whole loan financing facilities
    
    
    105,905
    
    
    
    105,905
    
    
    
    
    
    
    
    
    
    
    
    Senior Notes
    
    
    251,127
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    251,127Purchase commitments
    
    
    2,015,881
    
    
    
    2,015,881
    
    
    
    
    
    
    
    
    
    
    
    Total (2)
    
    $
    22,722,820
    
    
    $
    18,272,486
    
    
    $
    126,974
    
    
    $
    44,728
    
    
    $
    4,278,632
  (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 March 31, 2004 and
December 31, 2003 (in thousands): March 31, 2004
    
    December 31, 2003Carrying
    
    Fair
    
    Carrying
    
    FairAmount
    
    Value
    
    Amount
    
    ValueAssets:ARM securities
    
    $
    13,791,972
    
    
    $
    13,791,972
    
    
    $
    11,520,741
    
    
    $
    11,520,741Securitized ARM loans
    
    
    3,530,532
    
    
    
    3,554,688
    
    
    
    3,687,466
    
    
    
    3,703,420ARM loans collateralizing CDOs
    
    
    4,145,507
    
    
    
    4,213,753
    
    
    
    3,146,961
    
    
    
    3,138,634ARM loans held for securitization
    
    
    397,397
    
    
    
    397,486
    
    
    
    496,998
    
    
    
    497,271Hedging instruments
    
    
    18,738
    
    
    
    18,738
    
    
    
    40,356
    
    
    
    40,356Liabilities:Reverse repurchase agreements
    
    
    16,246,508
    
    
    
    16,246,508
    
    
    
    13,926,858
    
    
    
    13,926,858CDOs
    
    
    4,103,399
    
    
    
    4,135,540
    
    
    
    3,114,047
    
    
    
    3,134,560Whole loan financing facilities
    
    
    105,905
    
    
    
    105,905
    
    
    
    369,343
    
    
    
    369,343Senior Notes
    
    
    251,127
    
    
    
    265,838
    
    
    
    251,080
    
    
    
    267,750Hedging instruments
    
    
    208,478
    
    
    
    208,478
    
    
    
    113,518
    
    
    
    113,518
 Note 6. Common Stock On January 8, 2004, the Company filed a shelf registration statement on
Form S-3 for $750 million of equity and debt securities. On January
21, 2004, the registration statement was declared effective by the
Securities and Exchange Commission. 19




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##### Table of Contents



During February 2004, the Company completed a public offering of
4,000,000 shares of common stock and received net proceeds of $110.1
million. During the quarter ended March 31, 2004, the Company issued 698,400
shares of common stock through at-market transactions and received net
proceeds of $19.6 million under controlled equity offering programs. During the quarter ended March 31, 2004, the Company issued 1,351,706
shares of common stock under the Dividend Reinvestment and Stock
Purchase Plan (the DRSPP) and received net proceeds of $38.7 million. As of March 31, 2004, $630.8 million of the Companys registered
securities remained available for future issuance and sale under its
shelf registration statement. On December 16, 2003, the Company declared the fourth quarter 2003
dividend of $0.64 per share of common stock, which was paid on January
23, 2004 to shareholders of record as of December 31, 2003. On April 20, 2004, the Company declared the first quarter 2004 dividend
of $0.65 per share of common stock, which will be paid on May 17, 2004
to shareholders of record as of May 5, 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 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
    
    
    3,850
    
    
    
    (4,409
    )
    
    
    (559
    )Balance, March 31, 2003
    
    $
    47,339
    
    
    $
    (153,152
    )
    
    $
    (105,813
    )Balance, December 31, 2003
    
    $
    (43,314
    )
    
    $
    (99,464
    )
    
    $
    (142,778
    )Net change
    
    
    84,042
    
    
    
    (115,973
    )
    
    
    (31,931
    )Balance, March 31, 2004
    
    $
    40,728
    
    
    $
    (215,437
    )
    
    $
    (174,709
    )
 The net unrealized gain on the Companys ARM Loans of $92.5 million and
$7.9 million at March 31, 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
(the Plan), effective January 21, 2003. As of
March 31, 2004, there were 1,475,022 DERs outstanding, all of
which were vested, and 731,855 PSRs outstanding, of which 538,478 were
vested. The Company recorded an expense associated with DERs and 20




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##### Table of Contents



PSRs of $4.5 million and $1.7 million for the quarters ended March 31,
2004 and 2003, respectively. Of the expense recorded in the first
quarter of 2004, $1.4 million was the amount of dividend equivalents
paid on DERs and PSRs, $585.2 thousand was the amortization of unvested
PSRs and $2.5 million was the impact of the increase in the Companys
common stock price on the value of the PSRs which was recorded as a
fair value adjustment. Of the expense recorded in the first quarter of
2003, $1.0 million was the amount of dividend equivalents paid on DERs
and PSRs, $422.7 thousand was the amortization of unvested PSRs, and
$210.0 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. Note 9. Transactions with Affiliates The Company is managed externally by Thornburg Mortgage Advisory
Corporation (the Manager) under the terms of a Management Agreement
(the Agreement). During the quarters ended March 31, 2004 and 2003,
the Company reimbursed the Manager $1.3 million and $1.1 million for
expenses, respectively, in accordance with the terms of the Agreement.
As of March 31, 2004 and 2003, $1.2 million and $850.0 thousand,
respectively, was payable by the Company to the Manager for these
reimbursable expenses. For the quarters ended March 31, 2004 and 2003, the Company incurred
costs of $3.6 million and $2.5 million, respectively, in base
management fees in accordance with the terms of the Agreement. As of
March 31, 2004 and 2003, $1.3 million and $872.1 thousand,
respectively, was payable by the Company to the Manager for the base
management fee. For the three-month periods ended March 31, 2004 and 2003, the Manager
earned performance-based compensation in the amount of $8.3 million and
$6.2 million, respectively, in accordance with the terms of the
Agreement. As of March 31, 2004 and 2003, $8.3 million and $6.2
million, respectively, was payable by the Company to the Manager for
performance-based compensation. As of March 31, 2004, the aggregate balance of mortgage loans
outstanding to directors and officers of the Company, and to employees
of the Manager and other affiliates, amounted to $33.2 million, had a
weighted average interest rate of 3.61%, and maturities ranging between
2030 and 2034. 21




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##### Table of Contents



Item 2.  MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS Executive Overview Our goal is to acquire or originate adjustable and variable rate mortgage
(ARM) assets for our portfolio and manage them in such a way that we can
create earnings and dividend stability in the near term and earnings and
dividend growth in future periods. In order to achieve these objectives, we
must mitigate key risks in the mortgage portfolio lending business and,
simultaneously, pursue earnings growth strategies. Two of the principal risks
in the mortgage lending business are credit risk and interest rate risk. Our
three primary growth strategies are (i) to increase our higher margin, more
profitable mortgage loan origination business; (ii) to raise new equity capital
at a premium to book value in order to grow our assets and book value over
time; and (iii) to better use our existing capital base by diversifying our
funding sources, relying less on reverse repurchase agreements and more on
long-term collateralized debt obligations (CDOs) to finance our balance
sheet. During the first quarter of 2004, our assets grew 17% from $19.1 billion at
December 31, 2003 to $22.4 billion at March 31, 2004. Our net earnings
increased 4% from $0.67 for the first quarter of 2003 to $0.70 per share for
the first quarter of 2004. We raised $168.4 million of new equity capital
during the quarter by issuing 6.1 million common shares at an average net price
of $27.83 per share. Primarily as a result of raising this new common equity
and the retention of earnings, our book value per common share rose 7% from
$16.75 per share to $17.85 per share. Our book value growth outpaced our
earnings growth because we experienced a margin decline during the quarter due
to the costs associated with diversifying our funding sources and increasing
our hedged position in order to better position ourselves for expected
increases in interest rates. 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 quarter. We
acquired $3.6 billion of ARM securities during the quarter, 99.7% of which were
rated High Quality by at least one of either Standard & Poors Corporation or
Moodys Investors Service, Inc. (the Rating Agencies) (see page 28 for
definition of High Quality). Also, as interest rates began to move upward
during the prior quarter, our portfolio prepayment rate slowed to an average of
19% Constant Prepayment Rate (CPR) from 29% CPR in the previous 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 $908.9 million in new
assets during the quarter, an increase of 5% from originations in the first
quarter of 2003 of $864.1 million. We also acquired $89.0 million of loans
through bulk acquisitions as compared to $341.4 million during the first
quarter of 2003. As a result of these ARM loan originations and acquisitions,
as of March 31, 2004, we owned $8.1 billion in ARM Loans (see page 27 for
definition of ARM Loans), which amounted to 36% of our total assets. According to the Mortgage Bankers Association (MBA), in 2003, mortgage
originations industry-wide reached an unprecedented $3.8 trillion, a 53%
increase over the $2.5 trillion originated in 2002. This record activity was
primarily the result of low interest rates, which provided borrowers an
opportunity to refinance their mortgage debt. As of April 14, 2004, the MBA is
forecasting that overall residential loan originations for 2004 will decline
33% to $2.6 trillion based on an assumption that refinancing activity will
decline by 53%, generally as a result of higher interest rates and the belief
that most people who had an opportunity to refinance have done so. The same
forecast also estimates that residential ARM loan origination will only decline
18% in 2004, since, generally speaking, in higher interest rate environments,
ARM products become more attractive relative to 30-year fixed rate mortgage
products. For the week ended April 23, 2004, the MBA reported that ARM loan
originations accounted for 33% of total loan production versus 14% a year ago.
We believe our traditional ARM products, which have interest rates that reprice
in a year or less (Traditional ARMs), and hybrid ARM products, which have
fixed interest rates for an initial period of three to ten years before
converting to Traditional ARMs for their remaining terms to maturity (Hybrid
ARMs) provide borrowers with more attractive financing options than fixed-rate
mortgages and that we are well-positioned to benefit from borrowers increased
participation in ARM loans. Based on first quarter loan production and a loan
pipeline of $717.0 million at March 31, 2004, we believe we are on track to
achieve our $3.7 billion origination target for 2004, which represents a
decline of only 8% from our 2003 loan origination volume of $4.0 billion. We
believe we can continue to outperform industry trends in the near term because,
in addition to our already competitive mortgage interest rates, our focus on
ARM loans and our innovative product menu, we now have completed the expansion
of our lending approval to all 50 states and the District of Columbia. In
addition, we continue to increase our network of approved and active
correspondents, grow our internal sales force to help generate more loan
production through 22




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##### Table of Contents



correspondents, financial planners, corporate affinity groups and residential
home builders, and have increased our marketing budget from $2.1 million in
2003 to $4.0 million in 2004. We want to grow the percentage of originated
assets in our portfolio, because they have proven to be more profitable for us
than purchased mortgage assets. Funding Diversification During the first quarter of 2004, we continued to diversify our funding sources
by completing a CDO transaction in which we permanently financed $1.1 billion
of ARM loans. In these CDO transactions, we issue mortgage-backed securities
(MBS) to third party investors. We do not account for any of our ARM loan
securitizations as sales. These securities receive principal and interest
payments from the ARM loans placed in a trust, and these financings have no
further recourse to us. Consistent with our matched funding policy, $741.0
million of the CDOs issued in the first quarter are fixed-rate debt with terms
that match the initial fixed-rate terms of the underlying pool of Hybrid ARM
Loans financed by this transaction. Unlike reverse repurchase agreement
borrowings that are subject to margin calls based on the change in fair value
of the collateral or changes in margin requirements, CDOs are not subject to
any margin calls. A typical reverse repurchase agreement borrowing requires 4%
to 5% of initial capital plus an additional capital reserve in order to meet
any margin calls. As a result, we have developed a policy to maintain no less
than 8% of capital against our assets financed with recourse debt, which
includes a combination of our reverse repurchase agreement borrowings and our
whole loan financing lines. To the extent we have been able to fund a portion
of our balance sheet with CDOs, we have reduced our capital requirement and can
utilize freed up capital to acquire additional ARM assets. As of March 31,
2004, the $4.1 billion of CDO financing outstanding required approximately 2%
of equity capital, freeing up approximately $302 million of capital for the
acquisition of approximately $2.1 billion of additional ARM assets. CDOs
accounted for 20% of our borrowings as of March 31, 2004. Credit Quality We acquire excellent credit quality ARM assets and securitize the ARM loans we
either originate or acquire. These strategies create significant portfolio
liquidity and allow us to easily finance our portfolio. As of March 31, 2004,
97.2% of our ARM asset portfolio was High Quality as compared to 96.3% as of
December 31, 2003. 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 first 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 14 months old. Due to this lack of seasoning and, therefore,
lack of relevant historical data, we have recorded a loan loss allowance of
$8.4 million as of March 31, 2004 based on managements expectations given
industry loss experience on similar loans. Interest Rate Risk Management We use interest rate swap agreements (Swap Agreements), interest rate cap
agreements (Cap Agreements) and Eurodollar futures contracts (Eurodollar
Transactions) (collectively, Hybrid Hedging Instruments), as hedges to fix,
or cap, the interest rates on our short-term borrowings and on our CDOs. We
continue our strategy of hedging our financing cost such that we maintain a net
duration of our Hybrid ARM assets, related borrowings and Hybrid Hedging
Instruments of less than one year. The lower the duration gap, the less impact
interest rate changes will have on earnings. As of March 31, 2004, we had
entered into Swap Agreements and Eurodollar Transactions with a current
notional balance of $14.4 billion and delayed Swap Agreements with notional
balances totaling $689 million that become effective in the second quarter of
2004. Additionally, we had Cap Agreements with a current notional balance of
$2.2 billion. As a result, as of March 31, 2004, we measured the net duration
applicable to our Hybrid ARM portfolio, related borrowings and Hybrid Hedging
Instruments at approximately 1.3 months while the financing and hedging of all
of the Companys ARM assets resulted in a net duration of approximately 1.2
months. Although we experienced a declining interest rate environment from
2001 to 2003, we continue to employ a matched funding strategy as we acquire
Hybrid ARM assets in order to ensure stable earnings during periods of rising
interest rates. In essence, as we acquire ARM assets, we attempt to lock-in
a spread that is expected to provide a rate of return at or above our threshold
requirement. In order to stabilize the spread over the expected life of our
ARM assets, we use hedging instruments in conjunction with our borrowings to
approximate the repricing characteristics of our ARM assets. Given the
prepayment uncertainties of our ARM assets, there is no sure way to lock-in a
spread between the yield on our ARM assets and the related borrowing. However,
through active management, we believe we can continue to mitigate a significant
amount of net interest income volatility. See a discussion of Effects of
Interest Rate Changes on page 50. 23




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##### Table of Contents



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 first quarter of 2004, our operating
expenses as a percent of average assets were 0.40%, compared to 0.47% for the
same quarter of 2003 and 0.38% during the fourth quarter of 2003. We are able
to operate at this low level of operating expenses relative to the size of our
portfolio because we do not operate like a traditional mortgage lender. We
acquire many of our assets through MBS purchases and originate loans by
developing strategic partnerships with correspondent lenders, financial
planners and other intermediaries. We also use web-based marketing and a third
party call center and we do not have a retail branch network or commissioned
loan officers. We also do not acquire loans through mortgage brokers. In
addition, we have developed other strategic partnerships that provide
outsourced services on a variable cost basis to our customers in the name of
Thornburg Mortgage. We believe that this low, variable-cost model has allowed
us to operate profitably with a lower interest rate spread on our portfolio,
enabling us to mitigate significant risks normally associated with mortgage
origination and portfolio lending activities. One of the strategic decisions
we have been able to make as a result of our low-cost operating model is to
invest primarily in Agency, AAA, AA or A quality ARM loans. This strategy
has resulted in very low credit losses, a very liquid and readily financeable
portfolio, and a portfolio that has had low price volatility as compared to a
portfolio of 30-year, fixed-rate mortgage assets. Additionally, we have been
able to mitigate interest rate risk by entering into hedging transactions and
still achieve acceptable returns for our shareholders. Finally, by employing a
portfolio lending strategy, we do not depend on gain on sale income, which can
fluctuate significantly with loan origination volume. The increase in our earnings in the first quarter of 2004 compared to the
comparable quarter of 2003 and the fourth quarter of 2003 can be attributed to
a number of factors, including selling additional shares of common stock at a
premium to book value and increasing our use of capital relative to the amount
of common equity outstanding through the use of CDOs as discussed above, as
well as the Senior Notes issued during 2003. Although we experienced a decline
in our portfolio margin from 1.47% for the fourth quarter of 2003, to 1.40%
during the current quarter, we generated a 4% increase in net interest income
due to our capital growth. This capital growth led to an expansion of our
balance sheet, and our ability to more efficiently use shareholders equity.
The decline in our net interest spread is partially the result of additional
hedging costs as we position ourselves for expected increases in interest
rates. See further discussion of the change in our interest rate spreads in
Results of Operations For the Three Months Ended March 31, 2004, beginning on
page 43. 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 adjustable and variable rate
mortgage 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: 24




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
    
    Our Board of Directors is, and has always 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 of 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
or officers of the Company or any director, officer or employee of the
Manager from buying or selling our stock on the basis of material
nonpublic information, and prohibits communicating material nonpublic
information to others.
    
    We are managed externally by Thornburg Mortgage Advisory Corporation
(the Manager) under the terms of a management agreement (the
Management Agreement), subject to the supervision of our Board of
Directors. The Managers compensation is based on formulas tied to our
success in increasing common equity capitalization and generating net
income above defined targets. The Compensation Committee and the
independent directors annually evaluate the Managers performance and
determine whether the compensation paid to the Manager is reasonable in
relation to the nature and quality of services performed.
    
    We have a formal internal audit function to further the effective
functioning of our internal controls and procedures. Our internal audit
plan is based on a formal risk assessment and is intended to provide
management and the Audit Committee with an effective tool to identify
and address areas of financial or operational concerns and ensure that
appropriate controls and procedures are in place. We are currently
implementing Section 404 of the Sarbanes-Oxley Act of 2002, which
requires an evaluation of internal control over financial reporting in
association with our financial statements for the year ending December
31, 2004. Our Internet website address is www.thornburgmortgage.com. We make available
free of charge, through our Internet website, our annual report on Form 10-K,
our quarterly reports on Form 10-Q, our current reports on Form 8-K and any
amendments to those reports that we file or furnish pursuant to Section 13(a)
or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably
practicable after we electronically file such material with, or furnish it to,
the Securities and Exchange Commission (the SEC). You may also find our Code of Business Conduct and Ethics, Corporate Governance
Guidelines and the charters of the Audit Committee, Nominating/Corporate
Governance Committee and Compensation Committee of our Board of Directors at
our website. These documents are also available in print to anyone who
requests them by writing to us at the following address: 150 Washington
Avenue, Suite 302, Santa Fe, New Mexico, 87501, or by phoning us at (505)
989-1900. Please note that the reference to our website address is an inactive textual
reference made only for purposes of complying with SEC rules. Critical Accounting Policies and Estimates Our financial statements are prepared in conformity with generally accepted
accounting principles, many of which require the use of estimates and
assumptions. In accordance with recent SEC guidance, those material accounting
policies and estimates that we believe are the most critical to an investors
understanding of our financial results and condition and require complex
management judgment are discussed below.  
    
    Fair Value. We record our ARM securities,
commitments to purchase ARM loans and Hybrid Hedging
Instruments at fair value. The fair values of our
ARM securities and Hybrid Hedging Instruments are
generally based on market prices provided by certain
dealers who make markets in these financial
instruments or third party pricing services. If the
fair value of an ARM security, Hybrid Hedging
Instrument or other financial instrument is not
reasonably available from a dealer or a third party
pricing service, management estimates the fair value.
This requires management judgment in determining how
the market would value a particular ARM security,
Hybrid Hedging Instrument or other financial
instrument, based on characteristics of the security
we receive from the issuer and available market
information. The net unrealized gain or loss on
loans expected to be purchased from correspondent
lenders and bulk sellers is calculated using the same
methodologies that are used to value our ARM Loans,
adjusted for anticipated fallout for interest rate
lock 25




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commitments that will likely not be funded. The fair values reported reflect
estimates and may not necessarily be indicative of the amounts we could realize
in a current market exchange.  
    
    Loan Loss Reserves on ARM Loans. We maintain an
allowance for loan losses based on managements
estimate of credit losses inherent in our portfolio
of ARM Loans. The estimation of the allowance is
based on a variety of factors including, but not
limited to, current economic conditions, loan
portfolio composition, delinquency trends, credit
losses to date on underlying loans and remaining
credit protection. If the credit performance of our
ARM Loans is different than expected, we adjust the
allowance for loan losses to a level deemed
appropriate by management to provide for estimated
losses inherent in our ARM Loan portfolio. Two
critical assumptions used in estimating the loan loss
reserves are an assumed rate of default, which is the
expected rate at which loans go into foreclosure over
the life of the loans, and an assumed rate of loss
severity, which represents the expected rate of
realized loss upon disposition of the properties that
have gone into foreclosure.The following table presents a sensitivity analysis to show the impact on our
allowance for loan loss reserves of using different assumptions (in
thousands): Increase (Decrease)Changed Assumption
    
    in Loan Loss ReserveDefault assumption increased by 10%
    
    $
    1,347Default assumption decreased by 10%
    
    $
    (1,348
    )Loss severity assumption increased by 5%
    
    $
    1,621Loss severity assumption decreased by 5%
    
    $
    (1,621
    )
 The purpose of this analysis is to provide an indication of the impact
defaults and loss severity assumptions have on our estimate of the allowance
for loan losses. It is not intended to imply our expectation of future
default levels or changes in loss severity. We believe the current
assumptions used for defaults and loss severity are appropriate.  
    
    Basis Adjustments on ARM securities. Basis adjustments are a
designated component of the purchase discount on our ARM securities.
Certain of our ARM securities are rated less than Investment Grade and
represent subordinated interests in high-quality, first lien
residential mortgage loans where we own all of the securitized
classes. We generally purchase the less than Investment Grade classes
at a discount. Based upon managements use of analytical tools and
judgment, a portion of the purchase discount is subsequently accreted
as interest income under the effective yield method while the
remaining portion of the purchase discount is treated as a basis
adjustment which reflects the estimated unrealized loss on the
securities due to credit loss and interest rate exposure. Basis
adjustments are increased by recognizing an impairment loss when
management determines that there is a decline in the fair value of an
ARM security that is considered other than temporary and decreased
when there is improvement in the risk exposures. Any such
determinations are based on managements assessment of numerous
factors affecting the fair value of ARM securities, including, but not
limited to, current economic conditions, delinquency trends, credit
losses to date on underlying mortgages and remaining credit
protection. If management ultimately concludes that the basis
adjustments will not represent realized losses, the balances are
accreted into earnings over the remaining life of the security.
    
    Revenue Recognition. Interest income on ARM assets is a combination
of accruing interest based on the outstanding balance and contractual
terms of the assets and the amortization of yield adjustments using
generally accepted interest methods, principally the amortization of
purchase premiums and discounts. Premiums and discounts associated
with the purchase of ARM assets are amortized into interest income
over the lives of the assets using the effective yield method adjusted
for the effects of estimated prepayments. Estimating prepayments and
estimating the remaining lives of our ARM assets requires management
judgment, which involves consideration of possible future interest
rate environments and an estimate of how borrowers will behave in
those environments. The actual lives could be more or less than the
amount estimated by management at the time of purchase of the ARM
assets. For additional information on our significant accounting policies, see Note 1
to the Consolidated Financial Statements. General We are a single-family residential mortgage lender that originates, acquires
and retains investments in ARM assets, thereby providing capital to the
single-family residential housing market. Our ARM assets are comprised of
Traditional ARM and 26




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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. Like traditional banking institutions, our
income is generated primarily from the net spread or difference between the
interest income we earn on our ARM assets and the cost of our borrowings. Our
strategy is to maximize the long-term sustainable difference between the yield
on our investments and the cost of financing these assets, and to maintain that
difference through interest rate and credit cycles. While we are not a bank or savings and loan institution, our business purpose,
strategy, method of operation and risk profile are best understood in
comparison to such institutions. We finance the purchases and originations of
our ARM assets with equity capital, unsecured debt, short-term borrowings such
as reverse repurchase agreements, whole loan financing facilities, CDOs and
other collateralized financings that we may establish with approved
institutional lenders. When we borrow short-term or floating-rate funds to
finance our Hybrid ARM assets, we also enter into interest rate hedging
transactions, which fix our borrowing costs during the fixed-rate period of the
Hybrid ARM asset. We have a policy to operate with an Adjusted
Equity-to-Assets Ratio, a non-GAAP measurement, of at least 8% and we
typically operate with a 9 to 10% Adjusted Equity-to-Assets Ratio. (See
Capital Utilization on page 40 for a calculation of our Adjusted
Equity-to-Assets Ratio.) Since all of the assets we hold are ARM assets and we
pursue a matched funding strategy, we believe our exposure to changes in
interest rates can be prudently managed. Moreover, we focus on acquiring
primarily high quality assets to ensure our access to financing. Similarly, we
maintain strict credit underwriting standards and have experienced cumulative
credit losses of only $173.9 thousand on our loan portfolio since we began
acquiring loans in 1997. Our low cost operating structure has resulted in
operating costs well below those of other mortgage originators. We believe our
corporate structure differs from most lending institutions in that we are
organized for tax purposes as a real estate investment trust (REIT) and,
therefore, pay substantially all of our earnings in the form of dividends to
shareholders, without paying federal or state income tax at the corporate
level. Portfolio Strategies Our business strategy is to acquire and originate ARM assets to hold in our
portfolio, fund them using equity capital and borrowed funds, and generate
earnings from the difference, or spread, between the yield on our assets and
our cost of borrowing. 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 145 approved and active
correspondents, and we originate loans direct to consumers through our wholly
owned mortgage loan origination subsidiary, Thornburg Mortgage Home Loans, Inc.
(TMHL). Currently, TMHL is 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. 27




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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, or duration gap, of one year or less on
our Hybrid ARM assets (including commitments to purchase Hybrid ARM assets),
related borrowings and Hybrid Hedging Instruments. We use Hybrid Hedging
Instruments, as hedges to fix, or cap, the interest rates on our short-term
borrowings and on our CDOs. 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 mortgage interest rates fall
below the interest rates on ARM loans. To the extent there is an increase in
prepayment rates, resulting in a shortening of the expected lives of our ARM
assets, our net income and, therefore, the amount available for dividends could
be adversely affected. We believe that our status as a mortgage REIT makes an investment in our equity
securities attractive for tax-exempt investors, such as pension plans, profit
sharing plans, 401(k) plans, Keogh plans and Individual Retirement Accounts.
We do not invest in real estate mortgage investment conduit (REMIC) residuals
or other CMO residuals that would result in the creation of excess inclusion
income or unrelated business taxable income. Acquisition, Securitization and Retention of Traditional ARM and Hybrid ARM
Loans We acquire and originate A quality mortgage loans through TMHL from three
sources: (i) correspondent lending, (ii) direct retail loan originations, and
(iii) bulk acquisitions. Correspondent lending involves acquiring individual
loans from correspondent lenders whom we have approved and who originate the
individual loans using our product pricing, underwriting criteria and
guidelines, or criteria and guidelines that we have approved. Direct retail
loan originations are loans that we originate through intermediaries such as
financial advisors, corporate affinity clients and home builders or directly to
consumers via the Internet or by telephone. Bulk acquisitions involve
acquiring pools of whole loans, which are originated 28




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using the sellers guidelines and underwriting criteria. The loans we acquire
or originate are financed through warehouse borrowing arrangements pending
securitization for our portfolio. The loans acquired or originated by TMHL are first lien, single-family
residential Traditional ARM and Hybrid ARM loans with original terms to
maturity of not more than forty years and are either fully amortizing or are
interest-only up to ten years, and fully amortizing thereafter. All ARM loans that we acquire or originate for our portfolio bear an interest
rate tied to an interest rate index. Most loans have periodic and lifetime
constraints on how much the loan interest rate can change on any predetermined
interest rate reset date. The interest rate on each Traditional ARM loan
resets monthly, semi-annually or annually. The Traditional ARM loans generally
adjust to a margin over a U.S. Treasury index or a LIBOR index. The Hybrid ARM
loans have a fixed rate for an initial period, generally 3 to 10 years, and
then convert to Traditional ARM loans for their remaining term to maturity. We acquire ARM loans for our portfolio with the intention of securitizing them
into pools of High Quality ARM securities and retaining them in our portfolio
as securitized ARM loans. Alternatively, we may also use our loans as
collateral for CDOs. In order to facilitate the securitization or financing of
our loans, we generally create subordinate certificates, which provide a
specified amount of credit enhancement. Upon securitization, we generally
retain the securities issued, including the subordinate certificates, and
either finance them in the repurchase agreement market or through the issuance
of CDOs in the capital markets. Our investment policy limits the amount we may
retain of these below Investment Grade subordinate certificates, and
subordinate classes that we purchase in connection with a whole pool
securitization effected by third parties, to 17.5% of shareholders equity,
measured on a historical cost basis. We believe the acquisition and origination of ARM loans for securitization
benefits us by providing: (i) greater control over the quality and types of ARM
assets acquired; (ii) the ability to acquire ARM assets at lower prices, so
that the amount of the premium to be amortized will be reduced in the event of
prepayment; (iii) additional sources of new whole-pool ARM assets; and (iv)
generally higher yielding investments in our portfolio. We offer a loan modification program on all loans we originate and certain
loans we acquire. We believe this program promotes customer retention and
reduces loan prepayments. Under the terms of this program, a borrower pays a
fee to modify the mortgage loan to any then-available Hybrid or Traditional ARM
product that we offer at the offered retail interest rate plus 1/8%. During
the first quarter of 2004, we modified 142 loans with balances totaling $71.5
million. At April 13, 2004, the pipeline of loans to be modified totaled
$173.6 million which represents a significant increase in mortgage loan
modification activity compared to the fourth quarter of 2003 due to volatility
in interest rates. Financing Strategies We finance our ARM assets using equity capital, unsecured debt, short-term
borrowings such as reverse repurchase agreements, whole loan financing
facilities, CDOs, and other collateralized financings that we may establish
with approved institutional lenders. See Hedging Strategiesbelow for a
discussion of how we convert short-term borrowings into 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 three to twenty-five months.
The interest rates on these variable rate term reverse repurchase agreements
are generally indexed to either the one-month or three-month LIBOR rate, and
reprice accordingly. The fixed-rate reverse repurchase agreements have
original maturities generally ranging from 30 to 180 days. Generally, upon
repayment of each reverse repurchase agreement, we immediately pledge the ARM
assets used to collateralize the financing to secure a new reverse repurchase
agreement. 29




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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 equity capital
using a variety of different measures. The primary operating policy that
limits our borrowings and leverage is a requirement to maintain our Adjusted
Equity-to-Assets Ratio, a non-GAAP measurement, at a minimum of 8%. Our
Adjusted Equity-to-Assets Ratio represents the long-term capital (both equity
and Senior Notes) supporting our recourse or marginable debt. Recourse or
marginable debt generally consists of reverse repurchase agreements and whole
loan financing facilities. These forms of borrowing are short-term in nature,
mature on a frequent basis (weighted average maturity of 3.4 months as of March
31, 2004), need to be rolled over at each maturity and are subject to margin
call based on collateral value changes or changes in margin requirements.
Because of the short-term nature of these forms of financing, our policy
requires that we maintain significant excess capital and liquidity to meet
margin calls as a result of unexpected changes in margin requirements and
collateral value. Our policy is to maintain a capital cushion equal to
approximately twice the margin requirement when using these forms of
borrowings. Our margin requirements typically range between 4% and 5% for
these borrowings, so our policy requires that we maintain capital of at least
8%, and typically 9% to 10%, against the financing of these assets. This
capital cushion has proved to be more than adequate to support our borrowing
arrangements through a variety of interest rate and credit cycles. As we replace our reverse repurchase agreement borrowings with CDO financings,
the risk of margin calls, changes in margin requirements and potential rollover
risk is eliminated because CDO financings represent permanent, non-recourse
financing whose terms are established at the time of the financing and are not
subject to change. As a result, the need to maintain a capital cushion
comparable to what we maintain on our recourse borrowings is eliminated. For
purposes of maintaining an adequate capital cushion, our policy allows us to
eliminate all assets (and the associated equity capital) associated with CDO
financing from our operating capital ratio. Additionally, we eliminate from
our Adjusted Equity-to-Assets Ratio any unrealized market value adjustments,
recorded in Accumulated other comprehensive income (loss), from our equity
accounts, and we include our Senior Notes as an additional form of long-term
capital as if the notes were equity capital. (See calculation of the Adjusted
Equity-to-Assets Ratio on page 41.) Because the CDOs only require
approximately 2% of equity capital to support the CDO financing, versus the 8%
to 10% policy requirement on our recourse borrowings, we are able to use this
freed-up capital to acquire additional assets. We expect that we will be able
to retain and carry an increased amount of assets in the future as a percentage
of our equity capital base. Hedging Strategies We attempt to mitigate our interest rate risk by funding our ARM assets with
borrowings and hedging instruments 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 Swap Agreements, Eurodollar Transactions
and Cap Agreements that fix the interest rate on the borrowings such that the
net duration of the Hybrid ARM portfolio, the related borrowings and the
associated Hybrid Hedging Instruments is one year or less. A lower duration
indicates a lower expected volatility of earnings given future 30




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changes in interest rates. When we enter into a Swap Agreement, we agree to
pay a fixed rate of interest and to receive a variable interest rate, generally
based on LIBOR. We also enter into Eurodollar Transactions in order to fix the
interest rate changes on our forecasted three-month LIBOR-based liabilities.
Each Eurodollar futures contract is a three-month contract with a price that
represents the forecasted three-month LIBOR rate. Selling Eurodollar futures
contracts locks in a future interest rate. The difference between these two
values results in a gain or loss that offsets the change in the three-month
LIBOR rate and locks-in the forecasted three-month LIBOR rate for financing
purposes. We purchase Cap Agreements by incurring a one-time fee or premium.
Pursuant to the terms of the Cap Agreements, we will receive cash payments if
the interest rate index specified in any such Cap Agreement increases above
contractually specified levels. Therefore, such Cap Agreements have the effect
of capping the interest rate on a portion of our borrowings above a level
specified by the Cap Agreement. The notional balances of the Hybrid Hedging
Instruments generally decline over the life of these instruments. As of March
31, 2004, our Hybrid Hedging Instruments had a remaining average term to
maturity of 3.7 years before considering the effects of prepayments and when
combined with our Hybrid ARM assets and related borrowings had a net duration
of approximately 1.3 months, including the effects of prepayments. In general, our Traditional ARM assets have a maximum lifetime interest rate
cap, or ceiling, meaning that each ARM asset contains a contractual maximum
interest rate. Since our borrowings are not subject to equivalent interest
rate caps, we have also entered into Cap Agreements, so that the net margin on
our Traditional ARM assets with maximum lifetime interest rate caps will be
protected in high interest rate environments. These Cap Agreements are
referred to as Life Cap Hedging Instruments. Pursuant to the terms of these
Life Cap Hedging Instruments owned as of March 31, 2004, we will receive cash
payments if the applicable index, generally the three-month or six-month LIBOR
index, increases above contractually specified levels. The fair value of these
Cap Agreements generally increases when general market interest rates increase
and decreases when market interest rates decrease, helping to partially offset
changes in the fair value of our ARM assets related to the effect of the
lifetime interest rate cap. We are not currently purchasing Life Cap Hedging
Instruments because current interest rates are significantly lower than the
contractual life caps on our ARM assets. 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 March 31, 2004, $2.6 billion of our
Traditional ARM assets have periodic caps, representing 12.0% of total ARM
assets. We also enter into Eurodollar Transactions to manage interest rate risk
associated with commitments to purchase ARM loans (Pipeline Hedging
Instruments.) The gain (loss) on the Pipeline Hedging Instruments offsets the
gain (loss) recorded for the change in fair value of the loan commitments. We may enter into other hedging-type transactions designed to protect our
borrowing costs or portfolio yields from interest rate changes. We may also
purchase interest-only mortgage derivative assets or other mortgage
derivative products for purposes of mitigating risk from interest rate changes,
although we have not, to date, entered into these types of transactions. We
may also use, from time to time, futures contracts and options on futures
contracts on the Eurodollar, Federal Funds, Treasury bills and Treasury notes
and similar financial instruments to mitigate risk from changing interest
rates. The hedging transactions that we currently use generally are designed to
protect our net interest income during periods of changing market interest
rates. We do not hedge for speculative purposes. Further, no hedging strategy
can completely insulate us from risk, and certain of the federal income tax
requirements that we must satisfy to qualify as a REIT may limit our ability to
hedge, particularly with respect to hedging against periodic cap risk. We
carefully monitor and may have to limit our hedging strategies to ensure that
we do not realize excessive hedging income or hold hedging assets having excess
value in relation to total assets. 31




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Financial Condition Asset Quality At March 31, 2004, we held total assets of $22.4 billion, $21.9 billion of
which consisted of ARM assets. That compares to $19.1 billion in total assets
and $18.9 billion of ARM assets at December 31, 2003. Since commencing
operations, we have purchased either ARM securities (backed by Agency
Securities or privately-issued MBS) or ARM loans generally originated to A
quality underwriting standards. At March 31, 2004, 97.1% 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 March 31, 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
and 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) March 31, 2004ARM Securities
    
    ARM Loans
    
    TotalCarrying
    
    Portfolio
    
    Carrying
    
    Portfolio
    
    Carrying
    
    PortfolioValue
    
    Mix
    
    Value
    
    Mix
    
    Value
    
    MixHigh Quality:Agency Securities
    
    $
    2,955,568
    
    
    
    21.4
    %
    
    $
    2,451
    
    
    
    0.0
    %
    
    $
    2,958,019
    
    
    
    13.5
    %Privately Issued ARM Assets:AAA/Aaa Rating
    
    
    10,488,329
    
    
    
    76.1
    
    
    
    7,428,507
    (1)
    
    
    92.0
    
    
    
    17,916,836
    (1)
    
    
    81.9AA/Aa Rating
    
    
    279,675
    
    
    
    2.0
    
    
    
    113,256
    
    
    
    1.4
    
    
    
    392,931
    
    
    
    1.8Total Privately Issued ARM Assets
    
    
    10,768,004
    
    
    
    78.1
    
    
    
    7,541,763
    
    
    
    93.4
    
    
    
    18,309,767
    
    
    
    83.7Total High Quality
    
    
    13,723,572
    
    
    
    99.5
    
    
    
    7,544,214
    
    
    
    93.4
    
    
    
    21,267,786
    
    
    
    97.2Other Investment:Privately Issued ARM Assets:A Rating
    
    
    41,069
    
    
    
    0.3
    
    
    
    63,973
    
    
    
    0.8
    
    
    
    105,042
    
    
    
    0.5BBB/Baa Rating
    
    
    15,820
    
    
    
    0.1
    
    
    
    28,952
    
    
    
    0.4
    
    
    
    44,772
    
    
    
    0.2BB/Ba Rating and Below
    
    
    11,511
    
    
    
    0.1
    
    
    
    47,077
    (1)
    
    
    0.6
    
    
    
    58,588
    (1)
    
    
    0.3ARM loans pending securitization
    
    
    
    
    
    
    0.0
    
    
    
    397,647
    
    
    
    4.9
    
    
    
    397,647
    
    
    
    1.8Total Other Investment
    
    
    68,400
    
    
    
    0.5
    
    
    
    537,649
    
    
    
    6.7
    
    
    
    606,049
    
    
    
    2.8Loan Loss Reserves
    
    
    
    
    
    
    0.0
    
    
    
    (8,427
    )
    
    
    (0.1
    )
    
    
    (8,427
    )
    
    
    (0.0
    )Total ARM Portfolio
    
    $
    13,791,972
    
    
    
    100.0
    %
    
    $
    8,073,436
    
    
    
    100.0
    %
    
    $
    21,865,408
    
    
    
    100.0
    %
 32




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##### Table of Contents



December 31, 2003ARM Securities
    
    ARM Loans
    
    TotalCarrying
    
    Portfolio
    
    Carrying
    
    Portfolio
    
    Carrying
    
    PortfolioValue
    
    Mix
    
    Value
    
    Mix
    
    Value
    
    MixHigh Quality:Agency Securities
    
    $
    2,321,013
    
    
    
    20.1
    %
    
    $
    2,961
    
    
    
    0.0
    %
    
    $
    2,323,974
    
    
    
    12.3
    %Privately 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
    
    
    
    1.6
    
    
    
    436,184
    
    
    
    2.3Total Privately Issued 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 Investment:Privately Issued ARM Assets:A Rating
    
    
    46,287
    
    
    
    0.4
    
    
    
    64,795
    
    
    
    0.9
    
    
    
    111,082
    
    
    
    0.6BBB/Baa Rating
    
    
    14,577
    
    
    
    0.1
    
    
    
    29,210
    
    
    
    0.4
    
    
    
    43,787
    
    
    
    0.2BB/Ba Rating and Below
    
    
    8,189
    
    
    
    0.1
    
    
    
    41,657
    (2)
    
    
    0.6
    
    
    
    49,846
    (2)
    
    
    0.3ARM loans pending securitization
    
    
    
    
    
    
    0.0
    
    
    
    497,248
    
    
    
    6.8
    
    
    
    497,248
    
    
    
    2.6Total Other Investment
    
    
    69,053
    
    
    
    0.6
    
    
    
    632,910
    
    
    
    8.7
    
    
    
    701,963
    
    
    
    3.7Loan Loss Reserves
    
    
    
    
    
    
    0.0
    
    
    
    (7,993
    )
    
    
    (0.1
    )
    
    
    (7,993
    )
    
    
    (0.0
    )Total ARM Portfolio
    
    $
    11,520,741
    
    
    
    100.0
    %
    
    $
    7,331,425
    
    
    
    100.0
    %
    
    $
    18,852,166
    
    
    
    100.0
    %
  (1)
    
    As of March 31, 2004, the AAA Rating category includes $4.1 billion
of ARM loans collateralizing CDOs that have been credit enhanced to AAA
through overcollateralization in the amount of $30.6 million which is
included in the BB/Ba Rating and below category.(2)
    
    As of December 31, 2003, the AAA Rating category includes $3.1
billion of ARM loans collateralizing CDOs that have been credit enhanced
to AAA through overcollateralization in the amount of $24.1 million
which is included in the BB/Ba Rating and below category. As of March 31, 2004, 5 of the 17,897 loans in our ARM loan portfolio were
considered seriously delinquent (60 days or more delinquent) and had an
aggregate balance of $1.2 million. The average original effective
loan-to-value ratio on the delinquent loans and the acquired property was 78%.
We believe that our current level of basis adjustments and allowance for loan
losses is adequate to cover estimated losses from these loans. 33




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##### Table of Contents



ARM Loan Portfolio Characteristics The following table presents various characteristics of our ARM Loan portfolio
as of March 31, 2004. This information pertains to ARM loans held for
securitization, ARM loans held as collateral for CDOs and ARM loans securitized
for our own portfolio for which we retained credit loss exposure. The combined
unpaid principal balance of the loans included in this information is $8.0
billion. Average
    
    High
    
    LowOriginal loan balance
    
    $
    458,579
    
    
    $
    7,875,000
    
    
    $
    26,000Unpaid principal balance
    
    $
    449,429
    
    
    $
    7,875,000
    
    
    $
    1,013Coupon rate on loans
    
    
    4.30
    %
    
    
    9.13
    %
    
    
    1.55
    %Pass-through rate
    
    
    4.17
    %
    
    
    8.60
    %
    
    
    1.53
    %Pass-through margin
    
    
    1.92
    %
    
    
    4.73
    %
    
    
    0.23
    %Lifetime cap
    
    
    10.40
    %
    
    
    19.90
    %
    
    
    7.13
    %Original term (months)
    
    
    360
    
    
    
    480
    
    
    
    120Remaining term (months)
    
    
    345
    
    
    
    479
    
    
    
    27
  Geographic distribution (top 5 states):California
    
    
    26.3
    %Georgia
    
    
    11.6Colorado
    
    
    7.4New York
    
    
    7.3Florida
    
    
    7.1Occupancy status:Owner occupied
    
    
    82.7
    %Second home
    
    
    12.9Investor
    
    
    4.4Documentation type:Full/Alternative
    
    
    91.6
    %Other
    
    
    8.4Loan purpose:Purchase
    
    
    36.6
    %Cash out refinance
    
    
    30.5Rate & term refinance
    
    
    32.9Original effective
loan-to-value:80.01%-and over (2)
    
    
    3.0
    %70.01%-80.00%
    
    
    42.560.01%-70.00%
    
    
    24.450.01%-60.00%
    
    
    12.850.00% or less
    
    
    17.3Weighted average effective original
loan-to-value:
    
    
    65.7
    %
 Property type:Single-family
    
    
    86.1
    %Condominium
    
    
    12.1Other residential
    
    
    1.8ARM Loan type:Traditional ARM loans
    
    
    32.9
    %Hybrid ARM loans
    
    
    67.1ARM Interest Rate Caps:Initial Cap on Hybrid loans:3.00% or less
    
    
    2.6
    %3.01%-4.00%
    
    
    20.84.01%-5.00%
    
    
    62.45.01%-6.00%
    
    
    14.2Periodic Cap on Traditional ARM loans:None
    
    
    40.0
    %1.00% or less
    
    
    45.4Over 1.00%
    
    
    14.6
 Percent of interest-only loan balances: 85.6%
Weighted average length of interest-only period: 8.2 years FICO scores:801 and over
    
    
    2.3
    %751 to 800
    
    
    42.4701 to 750
    
    
    34.0651 to 700
    
    
    18.3650 or less
    
    
    3.0
 Weighted average FICO score 737 (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. 34




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##### Table of Contents



(2)
    
    All loans with an effective original loan-to-value ratio over 80% have
mortgage insurance. As of March 31, 2004 and December 31, 2003, we serviced $5.4 billion and $4.7
billion of our loans, respectively, and had 11,662 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) March 31, 2004
    
    December 31, 2003Carrying
    
    Portfolio
    
    Carrying
    
    PortfolioValue
    
    Mix
    
    Value
    
    MixTraditional ARM assets:Index:One-month LIBOR
    
    $
    786,000
    
    
    
    3.6
    %
    
    $
    598,989
    
    
    
    3.2
    %Six-month LIBOR
    
    
    2,003,392
    
    
    
    9.2
    
    
    
    1,777,494
    
    
    
    9.4One-year Constant Maturity Treasury
    
    
    799,390
    
    
    
    3.6
    
    
    
    1,079,970
    
    
    
    5.7Other
    
    
    118,989
    
    
    
    0.5
    
    
    
    124,440
    
    
    
    0.73,707,771
    
    
    
    16.9
    
    
    
    3,580,893
    
    
    
    19.0Hybrid ARM assets:Remaining fixed period:Within 1-5 years
    
    
    14,910,407
    
    
    
    68.2
    
    
    
    12,691,728
    
    
    
    67.3Over 5 years
    
    
    3,255,657
    
    
    
    14.9
    
    
    
    2,587,538
    
    
    
    13.718,166,064
    
    
    
    83.1
    
    
    
    15,279,266
    
    
    
    81.0Loan Loss Reserves
    
    
    (8,427
    )
    
    
    (0.0
    )
    
    
    (7,993
    )
    
    
    (0.0
    )$
    21,856,408
    
    
    
    100.0
    %
    
    $
    18,852,166
    
    
    
    100.0
    %
 The ARM portfolio had a current weighted average coupon of 4.29% at March 31,
2004. This consisted of a weighted average coupon of 4.34% on the hybrid
portion of the portfolio and a weighted average coupon of 3.45% on the rest of
the portfolio. If the portfolio had been fully indexed, the weighted average
coupon of the portfolio would have been 4.26%, based upon the current
composition of the portfolio and the applicable indices. Additionally, if the
non-hybrid portion of the portfolio had been fully indexed, the weighted
average coupon of that portion of the portfolio would have been 3.10%, also
based upon the current composition of the portfolio and the applicable indices.
The term fully indexed refers to an ARM asset that has an interest rate
currently equal to its applicable index plus a margin to the index that is
specified by the terms of the ARM asset. As of December 31, 2003, the ARM portfolio had a weighted average coupon of
4.31%. This consisted of a weighted average coupon of 4.35% on the hybrid
portion of the portfolio and a weighted average coupon of 3.77% on the rest of
the portfolio. If the portfolio had been fully indexed, the weighted average
coupon of the portfolio would have been 4.28%, based upon the current
composition of the portfolio and the applicable indices. Additionally, if the
non-hybrid portion of the portfolio had been fully indexed, the weighted
average coupon of the ARM portfolio would have been 3.26%, based upon the
composition of the portfolio and the applicable indices at that time. At March 31, 2004, the current yield of the ARM assets portfolio was 4.04%,
unchanged from December 31, 2003. While the weighted average interest rate
coupon discussed above decreased by 2 basis points, the increased level of
non-interest-earning principal payment receivables increased the yield by 2
basis points as of March 31, 2004. 35




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##### Table of Contents



Interest Rate Risk Management Our ARM asset portfolio had a weighted average term to the next repricing date
of 3.7 years as of March 31, 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 4.4 years at March 31, 2004. As of March 31, 2004, the
Hybrid ARM portfolio comprised 83.1% 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 Hedging Instruments with
maturities approximately matching the interest rate adjustment periods on our
ARM assets. Some of our borrowings bear variable or short-term (one year or
less) fixed interest rates because a portion of our ARM assets have interest
rates that adjust within one year. However, our Hybrid ARM portfolio is
financed with short-term borrowings that are hedged with Hybrid Hedging
Instruments that fix the interest rate on those borrowings such that the net
duration of the Hybrid ARM portfolio and the associated fixed-rate hedged
borrowings is one year or less. Duration is a calculation expressed in months
or years that is a measure of the expected price change of financial
instruments based on changes in interest rates. By maintaining a net duration
of less than one year, which is our maximum duration policy limit, the combined
price change of our Hybrid ARM portfolio, associated Hybrid Hedging Instruments
and other borrowings funding our Hybrid ARM portfolio is expected to be a
maximum of 1% for a 1% parallel shift in interest rates. A lower duration
indicates a lower expected volatility of earnings given future changes in
interest rates. As of March 31, 2004, the net duration applicable to our
Hybrid ARM portfolio was approximately 1.3 months while the net duration
applicable to all of our ARM assets was approximately 1.2 months. As of March 31, 2004 and December 31, 2003, we were counterparty to Swap
Agreements and Eurodollar Transactions having an aggregate current notional
balance of $14.4 billion and $12.5 billion, respectively. In addition, as of
March 31, 2004, the Company had entered into two delayed Swap Agreements, one
with a notional balance of $509 million becoming effective in April 2004, and
the second with a notional balance of $180 million becoming effective in June
2004. As of March 31, 2004, these Swap Agreements and Eurodollar Transactions
had a weighted average maturity of 3.6 years. In accordance with the Swap
Agreements, we will pay a fixed rate of interest during the term of these Swap
Agreements and receive a payment that varies monthly with the one-month LIBOR
rate. The combined weighted average fixed rate payable of the Swap Agreements
and Eurodollar Transactions was 2.97% and 3.02% at March 31, 2004 and December
31, 2003, respectively. As of March 31, 2004, ARM assets with a carrying value
of $124.8 million, including accrued interest, and cash totaling $70.2 million
collateralized the Swap Agreements. The net unrealized loss on Swap Agreements
at March 31, 2004 of $186.3 million included Swap Agreements with gross
unrealized gains of $2.7 million and gross unrealized losses of $189.0 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 March 31, 2004, the net unrealized loss 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 $199.8 million. We estimate that
over the next twelve months, $87.3 million of these net unrealized losses will
be reclassified from Accumulated other comprehensive income (loss) to interest
expense. As of March 31, 2004 and December, 31, 2003, our Cap Agreements, used to manage
our interest rate risk exposure on the financing of the Hybrid ARM loans
collateralizing our CDOs, had remaining notional amounts of $1.4 billion and
$1.6 billion, respectively. Included in these totals are Cap Agreements with
start dates ranging from 2006 to 2008 and notional balances totaling $371.1
million. The fair value of our Cap Agreements at March 31, 2004 and December
31, 2003 was $16.0 million and $25.4 million, respectively, and is included in
Hedging instruments on the Consolidated Balance Sheets. As of March 31,
2004, the unrealized loss on these Cap Agreements of $15.7 million was included
in Accumulated other comprehensive income (loss). In the twelve month period
following March 31, 2004, $28.1 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 9.67% and average 3.81%. The Cap Agreements had an average maturity of 4.9
years as of March 31, 2004. The initial aggregate notional amount of the Cap
Agreements declines over the period of the agreements, which expire between
2006 and 2013. Our Traditional ARM assets generally have a maximum lifetime interest rate cap
or ceiling, meaning that each Traditional ARM asset contains a contractual
maximum interest rate. Since our borrowings are not subject to equivalent
interest rate caps, we have entered into Cap Agreements that have the effect of
offsetting a portion of our borrowing costs above a level specified by the Cap
Agreement so that the net margin on our Traditional ARM assets will be
protected in high interest rate 36




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##### Table of Contents



environments. As of March 31, 2004, our Traditional ARM assets had an average
lifetime interest rate cap of 11.43%, far exceeding the current level of
interest rates. At March 31, 2004, these Cap Agreements had a remaining
notional balance of $838.1 million with an average final maturity of five
months, compared to a remaining notional balance of $841.3 million with an
average final maturity of eight months at December 31, 2003. At March 31,
2004, these Cap Agreements had no fair value, 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 6.00% to 12.00%
and average approximately 10.52%. Due to the current low level of interest
rates, we have decided not to purchase additional Cap Agreements for
Traditional ARM assets at this time, but will reevaluate this policy on an
ongoing basis. 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 fair value of the net unrealized gain on Pipeline Hedging Instruments at
March 31, 2004 and December 31, 2003 was $4.3 million and $953.4 thousand,
respectively, and is included in Hedging instruments on the Consolidated
Balance Sheets. Pipeline Hedging Instruments had remaining notional balances
of $374.0 million and $283.0 million at March 31, 2004 and December 31, 2003,
respectively. The net loss of $3.5 million on Pipeline Hedging Instruments at
March 31, 2004 is reflected in Gain on ARM assets on the Consolidated Income
Statements and partially offsets the $3.8 million gain recorded on loan
commitments recorded pursuant to SFAS 149, Amendment of Statement 133 on
Derivative Instruments and Hedging Activities. On March 9, 2004, the SEC released Staff Accounting Bulletin 105 (SAB 105)
providing guidance on how to account for a commitment to purchase a mortgage
loan prior to funding the loan. SAB 105 is intended to eliminate the current
diversity in practice that exists relating to the accounting for loan
commitments. SAB 105 is effective for loan commitments entered into after
March 31, 2003. Management believes that the Companys method of accounting
for loan commitments is consistent with the guidance provided by SAB 105. Asset Acquisitions During the quarter ended March 31, 2004, we purchased $3.6 billion of ARM
securities, 99.7% of which were High Quality assets and $997.9 million of ARM
loans, generally originated to A quality underwriting standards. Of the ARM
assets acquired during the first quarter of 2004, 92.6% were Hybrid ARM assets
and 7.4% were Traditional ARM assets generally indexed to LIBOR. The following
table compares our ARM asset acquisition and origination activity for the
quarters ended March 31, 2004, December 31, 2003 and March 31, 2003: ARM Asset Acquisitions(in thousands) For the quarters ended:March 31, 2004
    
    December 31, 2003
    
    March 31, 2003ARM Securities:Agency Securities
    
    $
    783,546
    
    
    $
    604,961
    
    
    $
    193,008High Quality, privately issued
    
    
    2,769,753
    
    
    
    2,250,481
    
    
    
    1,439,207Other privately issued
    
    
    10,553
    
    
    
    4,359
    
    
    
    12,2933,563,852
    
    
    
    2,859,801
    
    
    
    1,644,508ARM Loans:Bulk acquisitions
    
    
    88,959
    
    
    
    34,539
    
    
    
    341,423Correspondent originations
    
    
    813,030
    
    
    
    1,193,821
    
    
    
    763,882Direct retail originations
    
    
    95,882
    
    
    
    132,257
    
    
    
    100,216997,871
    
    
    
    1,360,617
    
    
    
    1,205,521Total acquisitions
    
    $
    4,561,723
    
    
    $
    4,220,418
    
    
    $
    2,850,029
 37




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##### Table of Contents



Since 1997, we have emphasized acquiring ARM assets at substantially lower
prices relative to par in order to reduce the potential impact on our earnings
as a result of rapid prepayments. In doing so, the average premium paid for
ARM assets acquired in the first three months of 2004 and for the year 2003 was
1.14% and 1.01%, of par, respectively, as compared to 3.29% of par in 1997. In
part, as a result of this strategy, the unamortized cost basis was 101.18% of
par as of March 31, 2004, down from 102.77% of par as of the end of 1997. As of March 31, 2004, we had commitments to purchase $1.3 billion of ARM
securities and $717.0 million of ARM loans through origination channels. Securitization Activity On March 31, 2004, we completed a CDO transaction in which we securitized $1.1
billion of our ARM loans into a series of multi-class ARM securities. The
securitization process benefits us by creating highly liquid assets that can be
readily financed in the reverse repurchase agreement market or by enabling us
to issue floating-rate and fixed-rate CDOs that represent permanent financing
and are not subject to margin calls. While TMHL transfers substantially all of
the ARM loans to separate bankruptcy-remote legal entities, on a consolidated
basis: (i) our securitizations are not accounted for as sales and (ii) we
retain economic interest and risk with regard to the loans. All discussions
relating to securitizations in this Form 10-Q are on a consolidated basis and
do not reflect the separate legal ownership of the loans by various
bankruptcy-remote legal entities that are our wholly-owned subsidiaries. Of
the loans that we securitized during the first quarter of 2004, 99.5% of our
resulting investment was rated at least Investment Grade and 0.5% of our
investment was rated below Investment Grade and provided credit support to the
Investment Grade securities. Prepayment Experience For the quarter ended March 31, 2004, our mortgage assets paid down at an
approximate average annualized Constant Prepayment Rate (CPR) of 19%,
compared to 29% for the quarter ended December 31, 2003 and 32% for the quarter
ended March 31, 2003. When prepayment experience increases, we have to
amortize our premiums over a shorter time period, resulting in a reduced yield
to maturity on our ARM assets. Conversely, if actual prepayment experience
decreases, 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 March 31, 2004, we had unencumbered assets
of $806.7 million, consisting of unpledged ARM assets, cash and cash
equivalents, and other assets. We had unencumbered assets of $712.4 million at
December 31, 2003. Our principal sources of liquidity are the reverse
repurchase agreement market, the issuance of CDOs and whole loan financing
facilities, as well as principal and interest payments from ARM assets. The
reverse repurchase agreement market is a $4 trillion market that has been a
readily available source of financing for mortgage assets, particularly those
rated AA or better. There is also a robust market for AAA-rated CDOs of the
type that we issue and this type of financing effectively eliminates rollover
and margin call risk for the related portion of our balance sheet. To
supplement our funding sources, we also issue equity securities and unsecured
long-term debt. We believe that our liquidity level is in excess of that
necessary to satisfy our operating requirements and we expect to continue to
use diverse funding sources to maintain our financial flexibility. Sources of Funds Our primary sources of funds for the quarter ended March 31, 2004 consisted of
reverse repurchase agreements, CDOs, whole loan financing facilities and
payments of principal and interest from our ARM assets. In the future, we
expect our primary sources of funds to remain the same. We have arrangements to enter into reverse repurchase agreements with 24
different financial institutions and on March 31, 2004, had borrowed funds from
18 of these firms. Reverse repurchase agreement borrowings outstanding at
March 31, 2004, had a weighted average effective cost of 1.20%. The reverse
repurchase agreements had a weighted average remaining term to maturity of 3.4
months, although we utilize Swap Agreements and Eurodollar Transactions to
extend the re-pricing characteristic of total borrowings to 2.8 years. As of
March 31, 2004, $15.7 billion of these borrowings were variable rate 38




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##### Table of Contents



term
reverse repurchase agreements. Because we borrow money under these agreements
based on the fair value of our ARM assets, and because changes in interest
rates can negatively impact the valuation of ARM assets, our borrowing ability
under these agreements may be limited and lenders may initiate margin calls in
the event interest rates change or the value of our ARM assets declines for
other reasons. Additionally, 1.0% of our ARM securities are rated less than AA
by the Rating Agencies and have less liquidity than assets that are rated AA or
higher. Mortgage assets rated AA or higher by the Rating Agencies derive their
credit rating based on subordination, guarantees or other credit enhancements.
In the event of dramatic changes in interest rates or performance of credit
support, we might find it difficult to borrow against such assets. External
disruptions to credit markets might also impair access to additional liquidity
and, therefore, we might be required to sell certain mortgage assets in order
to maintain liquidity. If required, such sales might be at prices lower than
the carrying value of the assets, which would result in losses. We had
adequate liquidity throughout the quarter ended March 31, 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. During the first quarter of 2004, we completed a CDO transaction in which we
permanently financed $1.1 billion of ARM loans from our ARM loan portfolio. In
this transaction, we issued AAA and AA-rated floating-rate pass-through
certificates totaling $362.1 million and AAA and AA-rated fixed-rate
pass-through certificates totaling $741.0 million to third party investors.
The interest rates on the floating-rate pass-through certificates reset monthly
and are indexed to the one-month LIBOR rate. The interest rates on the
fixed-rate pass-through certificates are based on the weighted average
pass-through rate of the pool of underlying Hybrid ARM loans which have initial
fixed-rate terms ranging from three to ten years and then convert to
Traditional ARM loans. In connection with the issuance of these CDOs, we
incurred costs of $3.5 million, which were deducted from the proceeds of the
transaction and are being amortized over the expected life of these CDOs. This
transaction was accounted for as a financing of the loans and represents
permanent financing that is not subject to margin calls. Based on the
estimated exposure to credit losses on the loans collateralizing the debt, the
structure of this transaction includes overcollateralization that provides $2.8
million of initial credit support and, if needed, additional credit support
from excess cash flows over the life of a subordinate certificate retained by
the Company. 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 March 31, 2004, the following CDOs were
outstanding (in thousands): All-in InterestDescription
    
    Principal Balance
    
    Rate (1)Floating-rate financing (2)
    
    $
    2,564,396
    
    
    
    1.54
    %Fixed-rate financing
    
    
    1,539,003
    
    
    
    3.80
    %Total
    
    $
    4,103,399
    
    
    
    2.39
    %
  (1)
    
    All-in interest rate includes the impact of issuance costs and Hedging
Instruments.(2)
    
    Includes financing hedged with Cap Agreements with a notional balance of
$1.4 billion and a weighted average strike price of 3.81% as of March 31,
2004. As of March 31, 2004, the CDOs were collateralized by ARM loans with a
principal balance of $4.1 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 March 31, 2004, we had entered into four whole loan financing facilities.
The interest rates on these facilities are indexed to one-month LIBOR and
reprice accordingly. These facilities have a total committed borrowing
capacity of $1.1 billion and an uncommitted capacity of $500 million and expire
between September 2004 and March 2005. We expect to renew these facilities in
the ordinary course of business. As of March 31, 2004, we had $105.9 million
borrowed against these whole loan financing facilities at an effective cost of
2.88%. 39




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##### Table of Contents



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 equity capital
using a variety of different measures. The primary operating policy that
limits our borrowings and leverage is a requirement to maintain our Adjusted
Equity-to-Assets Ratio, a non-GAAP measurement, at a minimum of 8%. Our
Adjusted Equity-to-Assets Ratio represents the long-term capital (both equity
and Senior Notes) supporting our recourse or marginable debt. Recourse or
marginable debt generally consists of reverse repurchase agreements and whole
loan financing facilities. These forms of borrowing are short-term in nature,
mature on a frequent basis (weighted average maturity of 3.4 months as of March
31, 2004), need to be rolled over at each maturity and are subject to margin
call based on collateral value changes or changes in margin requirements.
Because of the short-term nature of these forms of financing, our policy
requires that we maintain significant excess capital and liquidity to meet
margin calls as a result of unexpected changes in margin requirements and
collateral value. Our policy is to maintain a capital cushion equal to
approximately twice the margin requirement when using these forms of
borrowings. Our margin requirements typically range between 4% and 5% for
these borrowings, so our policy requires that we maintain capital of at least
8%, and typically 9% to 10%, against the financing of these assets. This
capital cushion has proved to be more than adequate to support our borrowing
arrangements through a variety of interest rate and credit cycles. As we replace our reverse repurchase agreement borrowings with CDO financings,
the risk of margin calls, changes in margin requirements and potential rollover
risk is eliminated, because CDO financings represent permanent non-recourse
financing whose terms are established at the time of the financing and are not
subject to change. As a result, the need to maintain a capital cushion
comparable to what we maintain on our recourse borrowings is eliminated. For
purposes of maintaining an adequate capital cushion, our policy allows us to
eliminate all assets (and the associated equity capital) associated with CDO
financing from our operating capital ratio. Additionally, we eliminate from
our Adjusted Equity-to-Assets Ratio any unrealized market value adjustments,
recorded as Accumulated other comprehensive income (loss) from our equity
accounts, and we include our Senior Notes as an additional form of long-term
capital as if the notes were equity capital. Because the CDOs only require
approximately 2% of equity capital to support the CDO financing, versus the 8%
to 10% policy requirement on our recourse borrowings, we are able to use this
freed-up capital to acquire additional assets. We expect that we will be able
to retain and carry an increased amount of assets in the future as a percentage
of our equity capital base. Further, because we treat our Senior Notes as a
substitute form of equity capital, our asset base is expected to grow even
further. 40




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##### Table of Contents



The following table presents the calculation of our Adjusted Equity-to-Assets
ratio, a non-GAAP measurement: (in thousands) March 31, 2004
    
    December 31, 2003Assets
    
    $
    22,409,921
    
    
    $
    19,118,799Adjustments:Net unrealized (gain) loss on ARM securities
    
    
    (41,175
    )
    
    
    42,717Net unrealized loss (gain) on hedging instruments
    
    
    12,940
    
    
    
    (8,655
    )ARM loans collateralizing CDOs
    
    
    (4,145,507
    )
    
    
    (3,146,961
    )Cap agreements
    
    
    (31,678
    )
    
    
    (31,692
    )Adjusted assets
    
    $
    18,204,501
    
    
    $
    15,974,208Shareholders equity
    
    $
    1,428,867
    
    
    $
    1,239,104Adjustments:Accumulated other comprehensive loss
    
    
    174,709
    
    
    
    142,778Equity supporting CDOs:CDOs
    
    
    4,103,399
    
    
    
    3,114,047ARM loans collateralizing CDOs
    
    
    (4,145,507
    )
    
    
    (3,146,961
    )Cap agreements
    
    
    (31,678
    )
    
    
    (31,692
    )(73,786
    )
    
    
    (64,606
    )Senior notes
    
    
    251,127
    
    
    
    251,080Adjusted shareholders equity
    
    $
    1,780,917
    
    
    $
    1,568,356Adjusted equity-to-assets ratio
    
    
    9.78
    %
    
    
    9.82
    %GAAP equity-to-assets ratio
    
    
    6.38
    %
    
    
    6.48
    %Ratio of historical equity
plus Senior Notes to
historical assets
    
    
    8.29
    %
    
    
    8.53
    %Estimated total risk-based
capital /risk-weighted assets
    
    
    26.09
    %
    
    
    26.26
    %
 The above table also presents three alternative capital utilization
measurements to our Adjusted Equity-to-Assets ratio. The first capital
utilization measurement is our GAAP equity-to-assets ratio, a calculation that
simply divides total equity by total assets. While the simplest of all
equity-to-assets calculations, it is not used by management to manage our
balance sheet because it includes factors such as unrealized gains and losses
on assets and Hedging Instruments deemed to be less important to the long-term
operating nature of our business, since our assets are not for sale and since
the unrealized gains and losses are not permanent impairments of our equity or
of these assets and Hedging Instruments. The second alternative capital utilization measurement is the ratio of
historical equity plus Senior Notes to historical assets. This is a non-GAAP
measurement that eliminates the market value adjustment of our assets and
Hedging Instruments included in Accumulated other comprehensive income (loss).
This calculation also includes Senior Notes as a component of our long-term
capital base. This measurement is calculated by dividing the sum of the
assets, net unrealized gain (loss) on ARM 41




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##### Table of Contents



securities and net unrealized gain (loss) on Hedging Instruments in the table
above by the sum of shareholders equity and Senior Notes in the table above.
We monitor this ratio in order to have a complete picture of the relationship
between our total asset and long-term capital position. The third alternative capital utilization measurement is a calculation of
estimated total risk-based capital divided by risk-weighted assets, a
regulatory calculation required to be made by banks and savings and loan
institutions that complies with Federal Reserve Board capital requirements.
Risk-based capital measures capital requirements for assets based on their
credit exposure as defined by the regulation, with lower credit risk assets
requiring less capital and higher credit risk assets requiring more capital.
Although we are not subject to these regulatory requirements, we focus our
efforts on only high quality assets. Therefore, our risk-based capital ratio
tends to be quite high when compared to banking institutions, and well in
excess of the regulatory minimum of 10% required for banks and savings and loan
institutions to qualify as well-capitalized. Equity Transactions In February 2004, we completed a public offering of 4,000,000 shares of common
stock and received net proceeds of $110.1 million. During the quarter ended March 31, 2004, we issued 1,351,706 shares of common
stock under the DRSPP and received net proceeds of $38.7 million. During the quarter ended March 31, 2004, we issued 698,400 shares of common
stock through controlled equity offering programs and received net proceeds of
$19.6 million. Off-Balance Sheet Commitments As of March 31, 2004, we had commitments in the ordinary course of business to
purchase or originate the following amounts of ARM assets (in thousands): ARM securities  private high quality
    
    $
    1,290,621ARM securities  private other
    
    
    8,275ARM loans  correspondent originations
    
    
    605,943ARM loans  direct originations
    
    
    111,042$
    2,015,881
 We also have entered into transactions whereby we expect to acquire the
remaining balance of certain AAA-rated Hybrid ARM securities, at a price of
par, between 2004 and 2008, when the fixed-rate period of the Hybrid ARM
securities terminates and the securities convert into Traditional ARM
securities with characteristics similar to the Traditional ARM securities held
in the current portfolio. We view these transactions as an alternative source
of Traditional ARM assets. The current balance of the Hybrid ARM securities is
approximately $2.3 billion, but is expected to be less than 25% of that, and
could be zero, at the time they convert into Traditional ARM securities. If we
decide not to acquire the Hybrid ARM securities when they convert into
Traditional ARM securities, then we are committed to pay or receive the
difference between par and the fair value of the Traditional ARM securities at
that time, as determined by an auction of the Traditional ARM securities. 42




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##### Table of Contents



Contractual Obligations As of March 31, 2004, we had the following contractual obligations (in
thousands): Payments Due by PeriodLess than
    
    1 - 3
    
    3 - 5
    
    More thanTotal
    
    1 year
    
    years
    
    years
    
    5 yearsReverse repurchase agreements
    
    $
    16,246,508
    
    
    $
    16,141,033
    
    
    $
    105,475
    
    
    $
    
    
    
    $
    CDOs (1)
    
    
    4,103,399
    
    
    
    9,667
    
    
    
    21,499
    
    
    
    44,278
    
    
    
    4,027,505Whole loan financing facilities
    
    
    105,905
    
    
    
    105,905
    
    
    
    
    
    
    
    
    
    
    
    Senior Notes
    
    
    251,127
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    251,127Purchase commitments
    
    
    2,015,881
    
    
    
    2,015,881
    
    
    
    
    
    
    
    
    
    
    
    Total (2)
    
    $
    22,722,820
    
    
    $
    18,272,486
    
    
    $
    126,974
    
    
    $
    44,728
    
    
    $
    4,278,632
  (1)
    
    Maturities of our CDOs are dependent upon cash flows received from the
underlying loans receivable. Our estimate of their repayment is based on
scheduled principal payments on the underlying loans receivable. This
estimate will differ from actual amounts to the extent we experience
prepayments and/or loan losses.(2)
    
    Our Consolidated Balance Sheets include a liability for Hedging
Instruments with negative market values, which are not reflected in this
table. Results of Operations For the Three Months Ended March 31, 2004 For the quarter ended March 31, 2004, our net income was $53.4 million, or
$0.70 basic and diluted earnings per share (EPS), based on a weighted average
of 76,631,000 shares outstanding. That compares to $39.1 million, or $0.67 per
share, basic and diluted EPS for the quarter ended March 31, 2003, based on
weighted average basic and diluted shares outstanding of 55,631,000 and
58,391,000, respectively, a 4.5% increase in our 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 Net
    
    G & A
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    NetFor the
    
    Interest
    
    Expense
    
    Mgmt
    
    Incentive
    
    Other
    
    Preferred
    
    Income/Quarter
    
    Income/
    
    (1)/
    
    Fee/
    
    Fee/
    
    (2)/
    
    Dividend/
    
    EquityEnded
    
    Equity
    
    Equity
    
    Equity
    
    Equity
    
    Equity
    
    Equity
    
    (ROE)Mar 31, 2002
    
    
    25.17
    %
    
    
    1.74
    %
    
    
    1.31
    %
    
    
    2.54
    %
    
    
    0.24
    %
    
    
    1.33
    %
    
    
    18.01
    %Jun 30, 2002
    
    
    23.80
    %
    
    
    1.84
    %
    
    
    1.23
    %
    
    
    2.40
    %
    
    
    0.33
    %
    
    
    1.08
    %
    
    
    16.92
    %Sep 30, 2002
    
    
    24.62
    %
    
    
    1.52
    %
    
    
    1.20
    %
    
    
    2.92
    %
    
    
    0.09
    %
    
    
    0.97
    %
    
    
    17.92
    %Dec 31, 2002
    
    
    24.90
    %
    
    
    2.32
    %
    
    
    1.17
    %
    
    
    2.96
    %
    
    
    (0.26
    )%
    
    
    0.89
    %
    
    
    17.82
    %Mar 31, 2003
    
    
    25.56
    %
    
    
    2.02
    %
    
    
    1.22
    %
    
    
    3.04
    %
    
    
    0.08
    %
    
    
    0.82
    %
    
    
    18.38
    %Jun 30, 2003
    
    
    23.93
    %
    
    
    2.31
    %
    
    
    1.17
    %
    
    
    3.03
    %
    
    
    (1.03
    )%
    
    
    0.73
    %
    
    
    17.72
    %Sep 30, 2003
    
    
    21.97
    %
    
    
    1.70
    %
    
    
    1.13
    %
    
    
    2.62
    %
    
    
    (0.27
    )%
    
    
    0.00
    %
    
    
    16.79
    %Dec 31, 2003
    
    
    22.79
    %
    
    
    2.10
    %
    
    
    1.11
    %
    
    
    2.59
    %
    
    
    0.23
    %
    
    
    0.00
    %
    
    
    16.76
    %Mar 31, 2004
    
    
    21.35
    %
    
    
    2.25
    %
    
    
    1.11
    %
    
    
    2.55
    %
    
    
    (0.90
    )%
    
    
    0.00
    %
    
    
    16.34
    %
   (1)
    
    General and administrative (G & A) expense excludes management and
performance fees and is net of fee income.(2)
    
    Other includes gain on ARM assets, hedging expense and provision for
credit losses. 43




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##### Table of Contents



Our return on equity declined slightly in this past quarter compared to the
same period in 2003 primarily due to decreased yield on our ARM asset portfolio
and increased long-term incentive award expense as a result of our increased
stock price, partially offset by gains on the sale of ARM securities. The
decline in our net interest spread was partially offset by more effective use
of capital. The following table presents the components of our net interest income for the
quarters ended March 31, 2004 and 2003: Comparative Net Interest Income Components
(in thousands) For the quarters ended March 31,2004
    
    2003Coupon interest income on ARM assets
    
    $
    205,748
    
    
    $
    129,983Amortization of net premium
    
    
    (10,316
    )
    
    
    (7,187
    )Cash and cash equivalents
    
    
    381
    
    
    
    400Interest income
    
    
    195,813
    
    
    
    123,196Reverse repurchase agreements
    
    
    44,113
    
    
    
    35,429CDOs
    
    
    11,905
    
    
    
    585Whole loan financing facilities
    
    
    3,378
    
    
    
    3,721Senior Notes
    
    
    5,235
    
    
    
    Hedging Instruments
    
    
    61,462
    
    
    
    31,427Interest expense
    
    
    126,093
    
    
    
    71,162Net interest income
    
    $
    69,720
    
    
    $
    52,034
 As presented in the table above, our net interest income increased by $17.7
million in the first quarter of 2004 compared to the first quarter of 2003.
The change was attributable to a $72.6 million increase in interest income
primarily due to an increased asset base, partially offset by a $54.9 million
increase in interest expense. Included in this increase in interest expense is
a $30.0 million increase resulting from the impact of Swap Agreements and
Eurodollar Transactions which is commensurate with the increase in borrowings
financing our Hybrid ARM assets and a $16.6 million increase due to our
issuance of CDOs and Senior Notes. Hybrid ARM assets totaled $18.2 billion and
$9.0 billion at March 31, 2004 and 2003, respectively, and the balance of our
CDOs and Senior Notes was $4.1 billion and $251.1 million, respectively, at
March 31, 2004. There were no CDOs or Senior Notes outstanding at March 31,
2003. 44




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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
(in thousands) For the quarters ended March 31,2004
    
    2003Interest
    
    
    
    
    
    
    
    
    
    InterestAverage
    
    Effective
    
    Income and
    
    Average
    
    Effective
    
    Income andBalance
    
    Rate
    
    Expense
    
    Balance
    
    Rate
    
    ExpenseInterest-Earning Assets:ARM assets
    
    $
    19,699,895
    
    
    
    3.97
    %
    
    $
    195,432
    
    
    $
    10,961,811
    
    
    
    4.48
    %
    
    $
    122,796Cash and cash equivalents
    
    
    210,833
    
    
    
    0.71
    
    
    
    381
    
    
    
    132,120
    
    
    
    1.21
    
    
    
    40019,910,728
    
    
    
    3.93
    
    
    
    195,813
    
    
    
    11,093,931
    
    
    
    4.44
    
    
    
    123,196Interest-Bearing Liabilities:Reverse repurchase agreements
    
    
    14,385,052
    
    
    
    1.23
    
    
    
    44,113
    
    
    
    9,330,058
    
    
    
    1.52
    
    
    
    35,429Plus: Cost of Hedging instruments (1)
    
    
    
    
    
    
    1.57
    
    
    
    56,304
    
    
    
    
    
    
    
    1.35
    
    
    
    31,427Hedged reverse repurchase agreements
    
    
    
    
    
    
    2.79
    
    
    
    100,417
    
    
    
    
    
    
    
    2.87
    
    
    
    66,856CDOs
    
    
    3,087,059
    
    
    
    1.54
    
    
    
    11,905
    
    
    
    18,876
    
    
    
    12.40
    
    
    
    585Plus: Cost of Hedging instruments (1)
    
    
    
    
    
    
    0.67
    
    
    
    5,158
    
    
    
    
    
    
    
    0.00Hedged CDOs
    
    
    
    
    
    
    2.21
    
    
    
    17,063
    
    
    
    
    
    
    
    12.40
    
    
    
    585Whole loan financing facilities
    
    
    750,840
    
    
    
    1.80
    
    
    
    3,378
    
    
    
    735,418
    
    
    
    2.02
    
    
    
    3,721Senior Notes
    
    
    251,097
    
    
    
    8.34
    
    
    
    5,235
    
    
    
    
    
    
    
    
    
    
    
    18,474,048
    
    
    
    2.73
    
    
    
    126,093
    
    
    
    10,084,352
    
    
    
    2.82
    
    
    
    71,162Net Interest Earning Assets
and Spread
    
    $
    1,436,680
    
    
    
    1.20
    %
    
    $
    69,720
    
    
    $
    1,009,579
    
    
    
    1.62
    %
    
    $
    52,034Yield on Net Interest Earning Assets (2)
    
    
    
    
    
    
    1.40
    %
    
    
    
    
    
    
    
    
    
    
    1.88
    %
  (1)
    
    Includes Swap Agreements and Eurodollar Transactions with notional
balances of $14.4 billion and $6.4 billion as of March 31, 2004 and 2003,
respectively, and Cap Agreements with notional balances of $1.4 billion as
of March 31, 2004.(2)
    
    Yield on Net Interest-Earning Assets is computed by dividing annualized
net interest income by the average daily balance of interest-earning
assets. 45




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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 March 31,2004 versus 2003Rate
    
    Volume
    
    Rate/Volume
    
    TotalInterest Income:ARM assets
    
    $
    (14,050
    )
    
    $
    97,886
    
    
    $
    (11,200
    )
    
    $
    72,636Cash and cash equivalents
    
    
    (162
    )
    
    
    239
    
    
    
    (96
    )
    
    
    (19
    )(14,212
    )
    
    
    98,125
    
    
    
    (11,296
    )
    
    
    72,617Interest Expense:Reverse repurchase agreements
    
    
    (1,726
    )
    
    
    36,222
    
    
    
    (935
    )
    
    
    33,561CDOs
    
    
    (481
    )
    
    
    95,127
    
    
    
    (78,168
    )
    
    
    16,478Whole loan financing facilities
    
    
    (413
    )
    
    
    79
    
    
    
    (9
    )
    
    
    (343
    )Senior Notes
    
    
    
    
    
    
    
    
    
    
    5,235
    
    
    
    5,235(2,620
    )
    
    
    131,428
    
    
    
    (73,877
    )
    
    
    54,931Net interest income
    
    $
    (11,592
    )
    
    $
    (33,303
    )
    
    $
    62,581
    
    
    $
    17,686
 As presented in the table above, net interest income increased by $17.7
million. This increase in net interest income is composed of unfavorable rate
and volume variances and a favorable variance from the combination of rate and
volume. As a result of the yield on our interest-earning assets decreasing to
3.93% during the first quarter of 2004 from 4.44% during the same period of
2003, a decrease of 51 basis points, and our cost of funds decreasing to 2.73%
from 2.82% during the same time period, a decrease of 9 basis points, there was
a net unfavorable rate variance of $11.6 million. This was primarily due to an
unfavorable rate variance on our ARM Assets portfolio and other
interest-earning assets that decreased net interest income by $14.2 million,
partially offset by a favorable rate variance on borrowings in the amount of
$2.6 million. The increased average size of our portfolio during the first
quarter of 2004 compared to the same period of 2003 decreased net interest
income in the amount of $33.3 million. The combination of changes in rates and
volume generated a $62.6 million increase in net interest income. The average
balance of our interest-earning assets was $19.9 billion during the quarter
ended March 31, 2004, compared to $11.1 billion during the same period of 2003
 an increase of 79.5%. 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
    
    AssetsMar 31, 2002
    
    $
    6,422
    
    
    
    5.59
    %
    
    
    0.64
    %
    
    
    4.95
    %
    
    
    3.30
    %
    
    
    1.65
    %
    
    
    1.97
    %Jun 30, 2002
    
    $
    7,846
    
    
    
    5.30
    %
    
    
    0.39
    %
    
    
    4.91
    %
    
    
    3.35
    %
    
    
    1.56
    %
    
    
    1.88
    %Sep 30, 2002
    
    $
    9,237
    
    
    
    5.16
    %
    
    
    0.42
    %
    
    
    4.75
    %
    
    
    3.19
    %
    
    
    1.56
    %
    
    
    1.84
    %Dec 31, 2002
    
    $
    10,105
    
    
    
    5.04
    %
    
    
    0.43
    %
    
    
    4.61
    %
    
    
    3.03
    %
    
    
    1.58
    %
    
    
    1.85
    %Mar 31, 2003
    
    $
    11,094
    
    
    
    4.96
    %
    
    
    0.52
    %
    
    
    4.44
    %
    
    
    2.82
    %
    
    
    1.62
    %
    
    
    1.88
    %Jun 30, 2003
    
    $
    13,144
    
    
    
    4.68
    %
    
    
    0.51
    %
    
    
    4.17
    %
    
    
    2.73
    %
    
    
    1.44
    %
    
    
    1.67
    %Sep 30, 2003
    
    $
    15,701
    
    
    
    4.41
    %
    
    
    0.56
    %
    
    
    3.85
    %
    
    
    2.53
    %
    
    
    1.32
    %
    
    
    1.53
    %Dec 31, 2003
    
    $
    18,327
    
    
    
    4.35
    %
    
    
    0.46
    %
    
    
    3.89
    %
    
    
    2.62
    %
    
    
    1.27
    %
    
    
    1.47
    %Mar 31, 2004
    
    $
    19,911
    
    
    
    4.29
    %
    
    
    0.36
    %
    
    
    3.93
    %
    
    
    2.73
    %
    
    
    1.20
    %
    
    
    1.40
    %
   (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. 46




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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)
    
    AdjustmentMar 31, 2002
    
    
    0.39
    %
    
    
    0.20
    %
    
    
    0.05
    %
    
    
    0.64
    %Jun 30, 2002
    
    
    0.22
    %
    
    
    0.13
    %
    
    
    0.04
    %
    
    
    0.39
    %Sep 30, 2002
    
    
    0.26
    %
    
    
    0.13
    %
    
    
    0.03
    %
    
    
    0.42
    %Dec 31, 2002
    
    
    0.30
    %
    
    
    0.09
    %
    
    
    0.04
    %
    
    
    0.43
    %Mar 31, 2003
    
    
    0.34
    %
    
    
    0.15
    %
    
    
    0.03
    %
    
    
    0.52
    %Jun 30, 2003
    
    
    0.32
    %
    
    
    0.13
    %
    
    
    0.06
    %
    
    
    0.51
    %Sep 30, 2003
    
    
    0.34
    %
    
    
    0.14
    %
    
    
    0.08
    %
    
    
    0.56
    %Dec 31, 2003
    
    
    0.28
    %
    
    
    0.11
    %
    
    
    0.07
    %
    
    
    0.46
    %Mar 31, 2004
    
    
    0.27
    %
    
    
    0.06
    %
    
    
    0.03
    %
    
    
    0.36
    %
  (1)
    
    Other includes the impact of interest-earning cash and cash equivalents
and restricted cash. We recorded hedging expense during the first quarter of 2004 of $158.1
thousand. At March 31, 2004, our Cap Agreements did not have any fair value,
compared to a fair value of $9.0 thousand as of December 31, 2003. Since we
are not currently applying hedge accounting to our Cap Agreements, we recorded
this change in fair value of the Cap Agreements as hedging expense. Included
in the above hedging expense we reclassified to earnings $149.1 thousand of the
transition adjustment recorded in Accumulated other comprehensive income (loss)
on January 1, 2002, in connection with the implementation of FAS 133. For the
quarter ended March 31, 2003, we recorded hedging ineffectiveness in the amount
of $10.6 thousand, hedging expenses of $17.3 thousand related to Eurodollar
Transactions and reclassified to earnings $149.2 thousand of the transition
adjustment, for total hedging expense of $177.1 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 March 31,
2004, our whole loans, including those that we have securitized, but with
respect to which we have retained credit loss exposure, accounted for 37.1% of
our portfolio of ARM assets or $8.1 billion. During the quarter ended March
31, 2004, we recorded loan loss provisions totaling $432.5 thousand to reserve
for estimated credit losses on loans. No provision was recorded in the first
quarter of 2003. We recorded a net gain on ARM assets of $3.5 million during the first quarter
of 2004. This gain consists of a $3.2 million gain on the sale of $345.5
million of ARM assets and a gain of $3.8 million on commitments to purchase
loans from correspondent lenders and bulk sellers, partially offset by a net
loss of $3.5 million on Eurodollar Transactions hedging the loan commitment
pipeline. We did not realize any gain or loss on ARM assets during the quarter
ended March 31, 2003. 47




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##### Table of Contents



The following table highlights the quarterly trend of operating expenses as a
percent of average assets: Annualized Operating Expense Ratios Total OperatingFor the
    
    Management Fee/
    
    Performance Fee/
    
    Other Expenses/
    
    Expenses/Quarter Ended
    
    Average Assets
    
    Average Assets
    
    Average Assets
    
    Average AssetsMar 31, 2002
    
    
    0.10
    %
    
    
    0.20
    %
    
    
    0.14
    %
    
    
    0.44
    %Jun 30, 2002
    
    
    0.10
    %
    
    
    0.19
    %
    
    
    0.14
    %
    
    
    0.43
    %Sep 30, 2002
    
    
    0.09
    %
    
    
    0.22
    %
    
    
    0.13
    %
    
    
    0.44
    %Dec 31, 2002
    
    
    0.09
    %
    
    
    0.22
    %
    
    
    0.18
    %
    
    
    0.49
    %Mar 31, 2003
    
    
    0.09
    %
    
    
    0.22
    %
    
    
    0.16
    %
    
    
    0.47
    %Jun 30, 2003
    
    
    0.08
    %
    
    
    0.21
    %
    
    
    0.18
    %
    
    
    0.47
    %Sep 30, 2003
    
    
    0.08
    %
    
    
    0.18
    %
    
    
    0.13
    %
    
    
    0.39
    %Dec 31, 2003
    
    
    0.07
    %
    
    
    0.17
    %
    
    
    0.14
    %
    
    
    0.38
    %Mar 31, 2004
    
    
    0.07
    %
    
    
    0.17
    %
    
    
    0.16
    %
    
    
    0.40
    %
 The most significant increases to our operating expenses for the quarter ended
March 31, 2004 compared to March 31, 2003 were the $2.8 million increase in the
expenses associated with our issuance of Dividend Equivalent Rights (DERs)
and Phantom Stock Rights (PSRs) together with our improved stock price
through March 31, 2004 and the $2.1 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. Our return on equity prior to the effect of the
performance-based fee of $8.3 million for the first quarter of 2004 was 18.89%,
whereas the threshold, the average 10-year treasury rate plus 1%, was 5.01%. The remaining $2.1 million increase in operating expenses from the quarter
ended March 31, 2003 to the same period of 2004 related primarily to increased
base management fees, expanded operations of TMHL and other corporate matters.
The base management fee paid to the Manager increased $1.1 million due to our
increased average shareholders equity and TMHLs operating costs increased by
$803.4 thousand. Our expense ratios are among the lowest of any company originating and
investing in mortgage assets, giving us what we believe to be a significant
competitive advantage over more traditional mortgage portfolio lending
institutions such as banks and savings and loan institutions. This competitive
advantage enables us to operate with less risk, such as credit and interest
rate risk, and still generate an attractive long-term return on equity when
compared to more traditional mortgage portfolio lending institutions. We pay the Manager an annual base management fee, generally based on average
shareholders equity as defined in the Management Agreement, payable monthly in
arrears as follows: 1.23% of the first $300 million of average shareholders
equity, plus 0.90% of average shareholders equity above $300 million, subject
to an annual inflation adjustment based on changes in the Consumer Price Index.
Since the management fee is based on shareholders equity and not assets, the
fee increases as we raise additional equity capital and thereby manage a larger
amount of invested capital on behalf of our shareholders. In order for the
Manager to earn a performance fee, the rate of return on the shareholders
investment, as defined in the Management Agreement, must exceed the average
10-year U.S. Treasury rate during the quarter plus 1%. Market Risks The market risk management discussion and the amounts estimated from the
analysis that follows are forward-looking statements that assume that certain
market conditions occur. Actual results may differ materially from these
projected results due to changes in our ARM portfolio and borrowings mix and
due to developments in the domestic and global financial and real estate
markets. Developments in the financial markets include the likelihood of
changing interest rates and the relationship of various interest rates and
their impact on our ARM portfolio yield, cost of funds and cash flows. As a financial institution that has only invested in U.S.-dollar denominated
instruments (primarily residential mortgage instruments) and has only borrowed
money in the domestic market, we are not subject to foreign currency exchange
or commodity price risk. Our market risk exposure is largely due to interest
rate risk. Interest rate risk is defined as the sensitivity of our current and
future earnings to interest rate volatility, variability of spread
relationships, the difference in 48




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##### Table of Contents



repricing intervals between our assets and liabilities and the effect that
interest rates may have on our cash flows, especially ARM portfolio
prepayments. Interest rate risk impacts our interest income, interest expense
and the market value on a large portion of our assets and liabilities. The
management of interest rate risk attempts to maximize earnings and to preserve
capital by minimizing the negative impacts of changing market rates, asset and
liability mix, and prepayment activity. The table below presents an approximation of the sensitivity of the market
value of our portfolio using a discounted cash flow simulation model.
Application of this method results in an estimation of the percentage change in
the market value of our assets, liabilities and Hedging Instruments per 100
basis point (bp) shift in interest rates expressed in yearsa measure
commonly referred to as duration. Positive portfolio duration indicates that
the market value of the total portfolio will decline if interest rates rise and
increase if interest rates decline. The closer duration is to zero, the less
interest rate changes are expected to affect earnings. Included in the table is
a Base Case duration calculation for an interest rate scenario that assumes
future rates are those implied by the yield curve as of March 31, 2004. The
other three scenarios assume interest rates are instantaneously 100, 200 and
300 bps higher than those implied by market rates as of March 31, 2004. The use of Hybrid Hedging Instruments is a critical part of our interest rate
risk management strategies, and the effects of these Hybrid Hedging Instruments
on the market value of the portfolio are reflected in the models output. This
analysis also takes into consideration the value of options embedded in our
mortgage assets including constraints on the repricing of the interest rate 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
March 31, 2004 Base Case
    
    Parallel +100 bps
    
    Parallel +200 bps
    
    Parallel +300 bpsAssets:Traditional ARMs
    
    0.28
    Years
    
    0.35
    Years
    
    0.57
    Years
    
    1.21
    YearsHybrid ARMs
    
    
    1.94
    
    
    
    2.31
    
    
    
    2.53
    
    
    
    4.00Total ARM assets
    
    
    1.69
    
    
    
    2.01
    
    
    
    2.23
    
    
    
    3.57Borrowings and hedges
    
    
    (1.60
    )
    
    
    (1.69
    )
    
    
    (1.70
    )
    
    
    (2.51
    )Net portfolio duration
    
    0.10
    Years
    
    0.22
    Years
    
    0.34
    Years
    
    0.64
    Years
 Based on the assumptions used, the model output suggests a very low degree of
portfolio price change given increases in interest rates, which implies that
our cash flow and earning characteristics should be relatively stable for
comparable changes in interest rates. As a comparison, the approximate base
case duration of an unhedged 10 year treasury, a conforming 30-year fixed
mortgage and a conforming 5/1 Hybrid ARM are 7.9, 5.4 and 2.6 years
respectively. Changes in assumptions including, but not limited to, volatility, mortgage and
financing spreads, prepayment behavior and defaults, as well as the timing and
level of interest rate changes, will affect the results of the model.
Therefore, actual results are likely to vary from modeled results. Although market value sensitivity analysis is widely accepted in identifying
interest rate risk, it does not take into consideration changes that may occur
such as, but not limited to, changes in investment and financing strategies,
changes in market spreads, and changes in business volumes. Accordingly, we
make extensive use of an earnings simulation model to further analyze our level
of interest rate risk. There are a number of key assumptions in our earnings simulation model. These
key assumptions include changes in market conditions that affect interest
rates, the pricing of ARM products, the availability of ARM products, and the
availability and the cost of financing for ARM products. Other key assumptions
made in using the simulation model include prepayment 49




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##### Table of Contents



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 March 31, 2004, based on the earnings simulation model, our potential
earnings increase (decrease) from our base case earnings forecast for a
parallel 100, 200 and 300 basis point rise in market interest rates over the
next twelve months and a commensurate slowdown in prepayment speeds as interest
rates rise, was 1.3%, 1.8% and (0.5%), respectively, of projected net income
for the twelve months ended March 31, 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 March 31, 2004, 12.0% of our total ARM assets were Traditional
ARM assets subject to periodic caps. Third, our ARM assets typically lag
changes in the applicable interest rate indices by 45 days, due to the notice
period provided to ARM borrowers when the interest rates on their loans are
scheduled to change. Interest rates can also affect our net return on Hybrid ARM assets (net of the
cost of financing Hybrid ARM assets). We estimate the duration of our Hybrid
ARM assets and have a policy to hedge the financing of the Hybrid ARM assets
such that the net duration of our borrowed funds, Hybrid Hedging Instruments
and the Hybrid ARM assets is less than one year. During a declining interest
rate environment, the prepayment of Hybrid ARM assets may accelerate causing
the amount of fixed-rate financing to increase relative to the amount of Hybrid
ARM assets, possibly resulting in a decline in our net return on Hybrid ARM
assets as replacement Hybrid ARM assets may have a lower yield than the ones
paying off. In contrast, during an increasing interest rate environment,
Hybrid ARM assets may prepay slower than expected, requiring us to finance a
higher amount of Hybrid ARM assets than originally anticipated at a time when
interest rates may be higher, resulting in a decline in our net return on
Hybrid ARM assets. In order to manage our exposure to changes in the
prepayment speed of Hybrid ARM assets, we regularly monitor the balance of
Hybrid ARM assets and make adjustments to the amounts anticipated to be
outstanding in future periods and, on a regular basis, make adjustments to the
amount of our fixed-rate borrowing obligations in future periods. Interest rate changes can also affect the availability and pricing of ARM
assets, which affects our investment opportunities. During a rising interest
rate environment, there may be less total loan origination and refinance
activity. At the same time, a rising interest rate environment may result in a
larger percentage of ARM products being originated, mitigating the impact of
lower overall loan origination and refinance activity. Conversely, during a
declining interest rate environment, consumers, in general, may favor
fixed-rate mortgage products, but there may be above average loan origination
and refinancing volume in the industry such that even a small percentage of ARM
product volume may result in sufficient investment opportunities.
Additionally, a flat yield curve may be an adverse environment for ARM products
because there may be little incentive for a consumer to choose an ARM product
over a 30 year fixed-rate mortgage loan and, conversely, in a steep yield curve
environment, ARM products may enjoy an above average advantage over 30 year
fixed-rate mortgage loans, increasing our investment opportunities. The
availability and fluctuations in the volume of ARM loans being originated can
also affect their yield to us as an investment opportunity. During periods of
time when there is a shortage of ARM products, their yield as an 50




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##### Table of Contents



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. Other Matters 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 March 31,
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 March 31, 2004, we
believe that we continue to qualify as a REIT under the provisions of the Code. We intend to conduct our business so as not to become regulated as an
investment company under the Investment Company Act of 1940. If we were to
become regulated as an investment company, our use of leverage would be
substantially reduced. The Investment Company Act exempts entities that are
primarily engaged in the business of purchasing or otherwise acquiring
mortgages and other liens on and interests in real estate (Qualifying
Interests). Under current interpretation of the staff of the SEC, in order to
qualify for this exemption, we must maintain at least 55% of our assets
directly in Qualifying Interests as defined in the Code. In addition, unless
certain mortgage securities represent all the certificates issued with respect
to an underlying pool of mortgages, such mortgage securities may be treated as
securities separate from the underlying mortgage loans and, thus, may not be
considered Qualifying Interests for purposes of the 55% requirement. We
calculated that we are 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 51




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our periodic SEC filings. In addition, during the quarter ended March 31, 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 March 31, 2004, there were no pending legal proceedings to which we
were a party or of which any of our property was subject. 
 Item 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES Not applicable 
 Item 3. DEFAULTS UPON SENIOR SECURITIES Not applicable 
 Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of our shareholders during the first quarter of 2004. 
 Item 5. OTHER INFORMATION None 
 Item 6. EXHIBITS AND REPORTS ON FORM 8-K; (a) Exhibits     See
Exhibit Index (b) Reports on Form 8-K     The
Company filed or furnished the following Current Reports on Form
8-K with the SEC during the quarter ended March 31, 2004:  (i)
    
    Current Report on Form 8-K, furnished on
January 22, 2004, attaching the Companys Press Release of
January 22, 3004 announcing the Companys earnings for the
year and the quarter ending December 31, 2003.(ii)
    
    Current Report on Form 8-K, filed on February
19, 2004, regarding entering into an Underwriting Agreement
with A.G. Edwards & Sons, Inc., as the lead manager and
Thornburg Mortgage Advisory Corporation relating to the sale
of 3,500,000 shares of the Companys common stock and
granting the lead manager an option to purchase up to an
additional 525,000 shares of common stock to cover
over-allotments that may occur during the offering process;
and regarding the securitization of approximately $1.1
billion of mortgage loans by TMHL, which were subsequently
sold to third party investors (Thornburg Mortgage Securities
Trust 2003-6).(iii)
    
    Current Report on Form 8-K, filed on March
22, 2004, regarding entering into a sales agreement with
Cantor Fitzgerald & Co. to sell up to 10,000,000 shares of
the Companys common stock from time to time through Cantor
Fitzgerald & Co., as sales agent. 52




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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: May 7, 2004
    
    /s/ Garrett ThornburgGarrett ThornburgChairman of the Board and Chief Executive Officer(Principal Executive Officer)Dated: May 7, 2004
    
    /s/ Larry A. GoldstoneLarry A. GoldstonePresident and Chief Operating Officer(authorized officer of registrant)Dated: May 7, 2004
    
    /s/ Richard P. StoryRichard P. StoryExecutive Vice President and Chief Financial Officer(Principal Financial and Accounting Officer)
 53




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Exhibit Index Exhibit Number
    
    Exhibit Description10.4.2
    
    Amendment No. 2 to Amended and Restated 2002 Long-Term Incentive Plan*31.1
    
    Certification of Chief Executive Officer pursuant to Rule 13a-14(a)
and 15d-14(a) of the Securities Exchange Act of 1934*31.2
    
    Certification of President and Chief Operating Officer pursuant to
Rule 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934*31.3
    
    Certification of Executive Vice President and Chief Financial Officer
pursuant to Rule 13a-14(a) and 15d-14(a) of the Securities Exchange
Act of 1934*32.1
    
    Certification of Chief Executive Officer pursuant to 18 U.S.C. Section
1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002*32.2
    
    Certification of President and Chief Operating Officer pursuant to 18
U.S.C. Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002*32.3
    
    Certification of Executive Vice President and Chief Financial Officer
pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906
of the Sarbanes-Oxley Act of 2002*
   *
    
    Being filed herewith. 54