THORNBURG MORTGAGE INC - 10-K Annual Report

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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

(MARK ONE)

X ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
- -------- EXCHANGE ACT OF 1934

FOR THE FISCAL YEAR ENDED: DECEMBER 31, 2001

OR

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
- ------- EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM TO
----------- ------------

COMMISSION FILE NUMBER: 001-11914

THORNBURG MORTGAGE, INC.
(Exact name of Registrant as specified in its Charter)

MARYLAND 85-0404134
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)

150 WASHINGTON AVENUE, SUITE 302
SANTA FE, NEW MEXICO 87501
(Address of principal executive offices) (Zip Code)

Registrant's telephone number, including area code (505) 989-1900

Securities registered pursuant to Section 12(b) of the Act:

Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the Registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.

Yes X No
--------- -------------

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
Regulation S-K is not contained herein, and will not be contained, to the best
of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]

At March 4, 2002, the aggregate market value of the voting stock held by
non-affiliates was $759,553,913, based on the closing price of the common stock
on the New York Stock Exchange.

Number of shares of Common Stock outstanding at March 4, 2002: 39,290,516

DOCUMENTS INCORPORATED BY REFERENCE:

Portions of the Registrant's definitive Proxy Statement dated March 27,
2002, issued in connection with the Annual Meeting of Shareholders of the
Registrant to be held on April 25, 2002, are incorporated by reference into
Parts I and III.

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THORNBURG MORTGAGE, Inc.
2001 FORM 10-K ANNUAL REPORT
TABLE OF CONTENTS

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PART I

ITEM 1. BUSINESS

GENERAL

We are a single-family residential mortgage origination and acquisition company
that originates, acquires and invests in adjustable-rate mortgage ("ARM") assets
comprised of ARM securities and ARM loans, thereby providing capital to the
single-family residential housing market. ARM securities represent interests in
pools of ARM loans, which often include guarantees or other credit enhancements
against losses from loan defaults. While we are not a bank or savings and loan,
our business purpose, strategy, method of operation and risk profile are best
understood in comparison to such institutions. We use our equity capital and
borrowed funds to invest in ARM assets and seek to generate income for
distribution to our shareholders based on the difference between the yield on
our ARM assets portfolio and the cost of our borrowings. 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 generally pass through
substantially all of our earnings to shareholders without paying federal or
state income tax at the corporate level. See "Federal Income Tax Considerations
- -- Requirements for Qualification as a REIT." We have five qualified REIT
subsidiaries, two of which are involved in financing our mortgage loan assets.
The two financing subsidiaries, Thornburg Mortgage Funding Corporation and
Thornburg Mortgage Acceptance Corporation, are consolidated in our financial
statements and federal and state tax returns.

We also have a wholly owned mortgage banking subsidiary, Thornburg Mortgage Home
Loans, Inc. ("TMHL"), that conducts our mortgage loan acquisition and
origination activities. TMHL acquires or originates single-family residential
mortgage loans through three channels: bulk acquisitions, correspondent lending
and direct lending. TMHL finances the loans through four warehouse borrowing
arrangements, pools loans for securitization and sale to us, and occasionally
sells loans to third parties. TMHL's two wholly owned special purpose
subsidiaries, Thornburg Mortgage Funding Corporation II and Thornburg Mortgage
Acceptance Corporation II, facilitate the securitization and financing of loans.
Effective December 31, 2001, we changed the tax status of TMHL and its
subsidiaries from taxable REIT subsidiaries to qualified REIT subsidiaries
because we determined that the activities of these subsidiaries are consistent
with permitted REIT activities and the change would not jeopardize our ability
to maintain our tax status as a REIT.

Thornburg Mortgage Advisory Corporation (the "Manager") carries out our
day-to-day operations, subject to the supervision of our Board of Directors and
under the terms of a management agreement (the "Management Agreement"). See
"Employees - The Management Agreement."

OPERATING POLICIES AND STRATEGIES

Investment Strategies

In the past, our investment strategy consisted solely of purchasing ARM
securities and large packages of ARM loans that other mortgage lending
institutions had originated and serviced. In 1999, we created a new
correspondent lending program, which currently includes approximately 50
approved financial institutions, that enables us to directly acquire ARM loans
that meet our underwriting guidelines. In 2000, we began originating loans
directly through TMHL. Currently, TMHL is authorized to lend in thirty-nine
states and intends eventually to be licensed nationwide. Our origination of
loans for our own portfolio will enable us to design our loan products to appeal
to high quality, more sophisticated borrowers. In addition, we believe that full
diversification of our sources for ARM loans and ARM securities will enable us
to consistently acquire and create high quality assets at attractive yields for
our portfolio.

We purchase ARM assets from broker-dealers and financial institutions that
regularly make markets in these assets. We also purchase ARM assets from other
mortgage suppliers, including mortgage bankers, banks, savings and loans,
investment banking firms, home builders and other firms involved in originating,
packaging and selling mortgage loans. We believe that we have a competitive
advantage in the acquisition and investment of these mortgage securities and
loans due to the low cost of our operations relative to traditional mortgage
investors, such as banks and savings and loans.

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Our mortgage assets portfolio may consist of either U.S. Government agency or
privately issued (generally publicly registered) mortgage pass-through
securities, multi-class pass-through securities, collateralized mortgage
obligations ("CMOs"), collateralized bond obligations ("CBOs") which are
generally backed by high quality mortgage-backed securities ("MBS"), ARM loans,
fixed rate MBS that have an expected duration of one year or less or short-term
investments that either mature within one year or have an interest rate that
reprices within one year. We also invest in hybrid ARM assets ("Hybrid ARMs").
Hybrid ARMs are typically 30-year loans that have 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 ARMs with
fixed rate periods of greater than five years to no more than 10% of our total
assets.

Our investment policy is to invest at least 70% of total assets in High Quality
adjustable and variable rate mortgage securities and short term investments.
High Quality means:

(1) securities that are unrated but are guaranteed by the U.S. Government
or issued or guaranteed by an agency of the U.S. Government;

(2) securities that are rated within one of the two highest rating
categories by at least one of either Standard & Poor's Corporation or
Moody's Investors Service, Inc. (the "Rating Agencies");

(3) securities 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 or Hybrid 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 on single-family,
multi-family, commercial or other real estate-related properties so
long as they are rated at least Investment Grade at the time of
purchase. "Investment Grade" generally means a security rating of
"BBB" or "Baa" or better by at least one of the Rating Agencies;

(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;

(3) fixed rate mortgage loans collateralized by first liens on
single-family residential properties originated for sale to third
parties;

(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 loan acquisition
and securitization efforts and that equal an amount no greater than
17.5% of our shareholders' equity, measured on a historical cost
basis.

We currently invest less than 3%, and have in the past generally invested less
than 15%, of our total assets in Other Investment assets, excluding loans held
for securitization. We do not expect to significantly increase our investment in
Other Investment securities despite their generally higher yield. This is
primarily due to the difficulty of financing such assets at reasonable financing
terms and values through all economic cycles.

Our status as a mortgage REIT enables tax-exempt investors, such as pension
plans, profit sharing plans, 401(k) plans, Keogh plans and Individual Retirement
Accounts, to purchase our securities. We generally do not invest in real estate
mortgage investment conduit ("REMIC") residuals or other CMO residuals which
would result in the creation of excess inclusion income or unrelated business
taxable income for tax-exempt investors and which would prevent such investors
from investing in our securities.

Acquisition and Securitization of ARM and Hybrid ARM Loans

Through TMHL, we acquire existing pools of ARM and Hybrid ARM loans and
individual loans directly from loan originators. We also originate mortgage
loans on a retail basis. We intend to securitize all loans that we acquire from
third parties and that we originate. We hold the securitized loans in our ARM
securities portfolio as High Quality assets. We

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believe that 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)
potentially higher yielding investments in our portfolio.

Bulk Acquisitions and Correspondent Lending

We use two methods, bulk acquisitions and correspondent lending, to acquire
third party-originated single-family residential ARM and Hybrid ARM loans. In
both methods, we use our in-house staff as well as third party credit
underwriters to verify the credit quality of the borrowers, as well as the
soundness of the mortgage collateral securing the individual loans.
Additionally, prior to the purchase of loans, we obtain representations and
warranties from each seller stating that each loan meets the seller's
underwriting standards and other requirements. A seller who breaches such
representations and warranties may be obligated to repurchase the loan. As added
security, we use the services of a third party document custodian to insure the
quality and accuracy of all individual mortgage loan closing documents and to
hold the documents in safekeeping. As a result, all of the original individual
loan closing documents that are signed by the borrower, other than the original
credit verification documents, are examined, verified and held by the custodian.

In the Bulk Acquisition Method (the "Bulk Method"), mortgage originators or
aggregators sell us pools of ARM loans at market prices, with or without the
servicing rights. The loans are originated using the seller's loan products,
programs and underwriting guidelines. Additionally, the originator performs the
credit review of the borrower, the appraisal of the property and the quality
control procedures. We generally only consider the purchase of loans when all of
the borrowers have had their incomes and assets verified, their credit checked
and appraisals of the properties have been obtained. We or a third party then
perform an independent underwriting review of the processing, underwriting and
loan closing methodologies that the originators used in qualifying a borrower
for a loan. We generally do not review all of the loans in a bulk package of
loans, but rather select loans for underwriting review based upon specific
criteria such as property location, loan size, effective loan-to-value ratios,
borrowers' credit score and other criteria that we believe to be important
indicators of credit risk.

In the Flow Acquisition Method (the "Flow Method"), we acquire mortgage loans
largely from correspondent lenders who originate such loans using our internally
developed loan programs, credit guidelines and underwriting criteria. In certain
cases, correspondents sell their own loan products to us, which are originated
according to the correspondents' pre-approved product specifications and
underwriting guidelines. We pre-qualify all correspondents to determine their
financial strength and the soundness of their own established in-house mortgage
procedures. Correspondents underwrite each borrower's credit and the value of
each property to our approved specifications. This is the same process that
originators/sellers use in the Bulk Method except that in the Flow Method we
have pre-approved or developed all of the application processing, loan
underwriting, credit approval and appraisal guidelines to meet our own credit
criteria and portfolio requirements.

Prior to closing, we or designated mortgage insurance companies review all of
the loans identified in the Flow Method to insure product quality and compliance
with our guidelines. We also obtain a mortgage score for each of the loans
acquired through the Flow Method. The mortgage score evaluates not only the
borrower's credit but also the geographic location of the property, the economic
viability of the area, the general market conditions and the loan product chosen
by the borrower. We believe that obtaining mortgage scores for the loans will
help in reducing our securitization costs by insuring that we purchase the
highest quality mortgage loans with the lowest risk possible. After closing, a
third party performs an additional quality control review of certain loans for
us in order to verify that such loans were properly underwritten and to confirm
that the loan documents are complete and properly executed.

In the past, the originator or seller of the mortgage loans that we acquired
through either the Bulk Method or the Flow Method generally retained the
servicing rights of such loans. In the third quarter of 2000, we began
purchasing the servicing rights on some of the loans that we acquired, with the
intent of providing borrowers with integrated, high quality customer service as
well as loan modification and refinance opportunities. These efforts are
designed to lower prepayment rates on the portfolio through customer retention.
In those cases where we buy the servicing rights together with the loans, we
contract with a qualified third party subservicer to service the loans on a
"private label" basis in our name.

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Direct Loan Origination

Our retail lending strategy consists of using our portfolio lending capability,
our competitive advantages and our technology to become a low cost, low
overhead, efficient lender that provides attractive and innovative mortgage
products, competitive mortgage rates, and a high level of customer service. By
eliminating intermediaries between us and the borrower, we expect to originate
loans at attractive yields while still offering borrowers competitive mortgage
rates. In expanding our retail origination business, we intend to continue our
strategy of acquiring only High Quality mortgages with the same emphasis on loan
quality as in our past loan acquisition activities.

We originate mortgage loans through TMHL. As of February 28, 2002, TMHL was
authorized to originate loans in the following thirty-nine states:

Alabama Kentucky North Carolina
Alaska Louisiana North Dakota
Arkansas Maine Oklahoma
California Maryland Oregon
Colorado Massachusetts South Carolina
Connecticut Michigan South Dakota
Delaware Minnesota Texas
Florida Mississippi Utah
Georgia Missouri Vermont
Idaho Montana Virginia
Illinois Nebraska West Virginia
Indiana Nevada Wisconsin
Iowa New Mexico Wyoming

We use one of two channels to originate loans directly with borrowers. We
originate loans using a call center, where borrowers can call us to inquire
about loan products and interest rates, as well as to seek advice and counseling
regarding qualifying for a loan and the approval process. In 2001, we expanded
this channel to employ third party call center specialists versed in mortgage
loan origination so that prospective borrowers are able to apply for a loan over
the telephone. A completed mortgage loan application along with a request for
additional supporting documentation is sent to the borrower for signature. Our
loan processors, or their third party agents, are responsible for working with
the borrower to complete the processing of the loan application, obtain a final
loan approval and schedule the loan for closing.

We also offer mortgages on-line utilizing a third party, private label,
web-based origination system. Prospective borrowers are able to look up mortgage
loan product and interest rate information through our website, submit an
application on-line and obtain a pre-approval of their loan. Once a mortgage
loan application has been submitted, one of our representatives or agents is
assigned the responsibility of completing the loan process on behalf of the
borrower.

The mortgage origination process is a labor- and document-intensive business
that requires significant "back office" systems and personnel. We have
contracted with a third party mortgage service provider to provide all of the
loan processing, underwriting, documentation and closing functions required to
originate and close mortgage loans. Additionally, another third party service
provider has staffed a mortgage loan call center for our benefit. These services
are provided on a private label basis, meaning that these providers will
identify themselves as being our representatives. The benefit to us of this
arrangement is that we pay for these services as we use them, without a
significant investment in personnel, systems, office space and equipment.
Regardless of the origination channel, our borrowers are able to track the
progress of an individual mortgage loan application as it makes its way through
processing, underwriting and closing using our website. In this way, prospective
borrowers are able to stay informed regarding the status of their loan
application.

We have also contracted with a third party to provide private label loan
servicing using our name for loans which we originate or purchase on a
servicing-released basis. This third party subservicer collects mortgage loan
payments, manages escrow accounts, provides monthly statements and notices to
borrowers, offers on-line mortgage servicing information and provides customer
service, loan collection, loss mitigation, foreclosure, bankruptcy and real
estate-owned management services. We pay fees for this service based on a fixed
fee schedule and the number of loans serviced.

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Securitization of ARM Loans

We acquire ARM loans for our portfolio with the intention of securitizing them
into pools of High Quality ARM securities. In order to facilitate the
securitization of our loans, we generally create subordinate certificates, which
provide a limited amount of credit enhancement, and, at times, we purchase an
insurance policy from a third party financial guarantor that "wraps" the
remaining balance of the loans to a credit rating of "AA" or better. Upon
securitization, we hold the High Quality ARM securities and the subordinate
certificates in our portfolio which we then finance in the repurchase agreement
market or through the issuance of debt obligations in the capital markets. We
have a policy that limits the amount of subordinate certificates created from
these securitization efforts and rated below Investment Grade that we may hold
in our portfolio to 17.5% of our shareholders' equity, as measured on a
historical cost basis.

We also securitize eligible loans through a Fannie Mae program. We exchange
pools of our eligible loans for Fannie Mae MBS. The MBS pay us interest and
principal derived from the interest and principal payments on the underlying
mortgages, less a fee paid to the servicer of the loans, and less a guaranty fee
paid to Fannie Mae. In this way, we no longer have any credit exposure to the
pool of mortgages and have exchanged the pool of mortgages for a High Quality
asset. We also negotiate with Fannie Mae to securitize otherwise ineligible
products through this program, although occasionally we will retain the credit
exposure for the pool. See "Fannie Mae ARM Programs."

Financing Strategies

We finance the purchase of ARM assets using (i) equity capital and (ii)
borrowings, such as reverse repurchase agreements, dollar-roll agreements,
borrowings under lines of credit, and other secured or unsecured financings
which we may establish with approved institutional lenders. We have established
lines of credit and collateralized financing agreements with twenty-two
different financial institutions. We generally expect to maintain an
equity-to-assets ratio of between 8% and 10%, as measured on a historical cost
basis. This ratio may vary from time to time within the above stated range
depending upon market conditions and other factors that our management deems
relevant, but cannot fall below 8% without the approval of our Board of
Directors.

Our borrowings are primarily at short term rates and in the form of reverse
repurchase agreements using our ARM securities as collateral. 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. 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. In the event of the insolvency or bankruptcy of a lender
during the term of a reverse repurchase agreement, the lender, under the Federal
Bankruptcy Code, may be allowed to assume or reject the agreement to resell the
assets. If a bankrupt lender rejects its obligation to resell pledged assets to
us, our claim against the lender for the resulting damages may be treated as one
of many unsecured claims against the lender's assets. These claims would be
subject to significant delay and, if and when payments are received, they may be
substantially less than the damages that we actually suffer. To mitigate this
risk, we enter into collateralized borrowings with only financially sound
institutions approved by our Board of Directors, including a majority of
unaffiliated directors, and monitor the financial condition of such institutions
on a regular, periodic basis.

We also finance the purchase of ARM assets by issuing debt obligations in the
capital markets, which are collateralized by securitized pools of our ARM assets
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. Using such a
structure enables us to issue debt that will not be subject to margin calls once
the debt obligation has been issued.

We also enter into financing facilities 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 credit lines to finance our acquisition of whole loans while
we are accumulating loans for securitization or until we arrange more permanent
financing in a capital markets, collateralized debt transaction.

Our Bylaws limit borrowings, excluding the collateralized borrowings in the form
of reverse repurchase agreements, dollar-roll agreements and other forms of
collateralized borrowings discussed above, to no more than 300% of our net
assets, on a

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consolidated basis, unless approved by a majority of our unaffiliated directors.
This limitation generally applies only to our unsecured borrowings. For this
purpose, the term "net assets" means our total assets (less intangibles) at
cost, before deducting depreciation or other non-cash reserves, less total
liabilities, as calculated at the end of each quarter in accordance with
generally accepted accounting principles. Accordingly, the 300% limitation on
unsecured borrowings does not affect our ability to finance our total assets
with collateralized borrowings.

Hedging Strategies

We make use of hedging transactions to mitigate the impact of certain adverse
changes in interest rates on our net interest income and fair value changes of
our ARM assets. In general, ARM assets have a maximum lifetime interest rate
cap, or ceiling, meaning that each ARM asset contains a contractual maximum
rate. This lifetime interest rate cap is a component of the fair value of an ARM
asset and can affect our net interest income. The borrowings that we incur to
finance our ARM assets portfolio are not subject to equivalent interest rate
caps. Accordingly, we purchase interest rate cap agreements ("Cap Agreements")
to prevent our borrowing costs from exceeding the lifetime maximum interest rate
on our ARM assets. These Cap Agreements have the effect of offsetting a portion
of our borrowing costs if prevailing interest rates exceed the rate specified in
the Cap Agreement. A Cap Agreement is a contractual agreement for which we pay a
fee, which may at times be financed, typically to either a commercial bank or
investment banking firm. Pursuant to the terms of the Cap Agreements owned as of
December 31, 2001, we will receive cash payments if the applicable index,
generally the three- or six-month LIBOR index, increases above certain specified
levels, which range from 5.875% to 12.00% and average approximately 10.05%. 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.

In addition, ARM assets are generally 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% per semiannual adjustment or 2%
per annual adjustment. The borrowings that we incur do not have similar periodic
caps. We generally do not hedge against the risk of our borrowing costs rising
above the periodic interest rate cap level on the ARM assets because 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. We attempt to mitigate the
effect of periodic caps in several ways. First, the yield on our ARM assets can
change by more than the 1% or 2% per periodic interest rate adjustment
limitation depending upon how prepayment activity changes as interest rates
change. Second, beginning in 1998, we began to acquire variable rate CMOs and
CBOs, Hybrid ARMs and certain other ARM loans that do not have a periodic cap.
As of December 31, 2001, approximately $4.1 billion of our ARM securities and
ARM loans did not have periodic caps or were Hybrid ARMs, representing
approximately 71% of total ARM assets.

We attempt to mitigate our interest rate risk by funding our ARM assets with
borrowings that have maturities that approximately match the interest rate
adjustment periods on our ARM assets. Accordingly, most of our borrowings bear
variable or short term fixed (one year or less) interest rates because, as of
December 31, 2001, 58.3% of our ARM assets had interest rates that adjust within
one year. However, for that part of our portfolio that is financing our Hybrid
ARMs, which generally have fixed interest rate periods of from 3 to 10 years
and, as of December 31, 2001, averaged a 3.7-year fixed rate period, we extend
the maturity of our borrowings such that the difference between the duration of
a Hybrid ARM and the duration of the fixed-rate liabilities and equity funding a
Hybrid ARM have a duration difference of no more than one year. By maintaining a
duration mismatch of less than one year, we expect the price change of our
Hybrid ARM portfolio to be a maximum of 1% for every 1% change in interest
rates. We generally accomplish this fixed rate maturity extension through the
use of interest rate swap agreements in which we contractually agree to pay a
fixed interest rate for a specified term and from which we receive a payment
that varies monthly with the one month LIBOR Index. As of December 31, 2001, our
current interest rate swap portfolio that hedged the financing of Hybrid ARMs
had a remaining fixed rate term to maturity of 2.8 years and a duration mismatch
of 0.17 years, which is in compliance with our hedging policy.

We may also enter into interest rate swap agreements to manage the average
interest rate reset period on our borrowings that finance non-Hybrid ARMs. In
accordance with the terms of the swap agreements, we pay a fixed rate of
interest during the term of the agreements and receive a payment that varies
monthly with the one month LIBOR Index. These agreements have the effect of
fixing our borrowing costs on a similar amount of swaps that we own and, as a
result, the interest rate variability of our borrowings is reduced. We may also
use interest rate swap agreements from time to time to change from one interest

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rate index to another interest rate index and thus decrease further the basis
risk between our interest-yielding assets and the financing of such assets.

In the past, the ARM assets that we held were generally purchased at prices
greater than par. We amortize the premiums paid for these assets over their
expected lives using the level 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. To mitigate the adverse effect of an
increase in prepayments on our ARM assets, we emphasize the purchase of ARM
assets at prices at or below par. Our portfolio of ARM assets is currently held
at a net premium of 0.94%, down from 2.83% as of the end of 1997. We may also
purchase limited amounts of "principal only" mortgage derivative assets backed
by either fixed rate mortgages or ARM assets as a hedge against the adverse
effect of increased prepayments. To date, we have not purchased any "principal
only" mortgage derivative assets.

We may enter into other hedging-type transactions designed to protect our
borrowings costs or portfolio yields from interest rate changes. We may also
purchase "interest only" mortgage derivative assets or other derivative products
for purposes of mitigating risk from interest rate changes. We have not, to
date, entered into these types of transactions, but may do so in the future. In
addition to the instruments described above, 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. In
order to use these instruments, we became registered and received an exemption
from being classified as a "Commodity Pool Operator" by the Commodity Futures
Trading Commission.

Effective January 1, 2001, we implemented Financial Accounting Standards No.
133, Accounting for Derivative Instruments and Hedging Activities ("SFAS 133").
SFAS No. 133 established a framework of accounting rules that standardizes
accounting and reporting for all derivative instruments and requires that all
derivative financial instruments be carried on the balance sheet at fair value.
We expect to continue to use derivative instruments to the extent that we
believe that the use of the derivative instruments meets our financial goals.

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 intend to 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 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. See "Federal Income Tax Considerations -
Requirements for Qualification as a REIT."

Operating Restrictions

Our Board of Directors has established our operating and investing policies and
strategies, and any revisions in such policies and strategies require the
approval of the Board of Directors, including a majority of the unaffiliated
directors. In general, the Board of Directors has the power to modify or alter
such policies without the consent of our shareholders.

We have elected to qualify as a REIT for tax purposes. We have adopted certain
compliance guidelines, which include restrictions on our acquisition, holding
and sale of assets, thus limiting the investment strategies that we may employ.
Substantially all the assets that we have acquired and will acquire for
investment are expected to be Qualified REIT Assets as defined by the Internal
Revenue Code of 1986, as amended (the "Code"). Our whole loans and our ARM
securities and other MBS fall within the definition of Qualified REIT Assets.

We closely monitor our purchases of ARM assets and the income from such assets,
including from our hedging strategies, so that we maintain our qualification as
a REIT at all times. We developed certain accounting systems and testing
procedures with the help of qualified accountants and tax experts to facilitate
our ongoing compliance with the REIT provisions of the Code. See "Federal Income
Tax Considerations - Requirements for Qualification as a REIT." We do not
purchase any assets from or enter into any servicing or administrative
agreements (other than the Management Agreement) with any entities affiliated
with the Manager.

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We at all times intend to conduct our business so that we are not regulated as
an investment company under the Investment Company Act of 1940. The Investment
Company Act exempts entities from regulation that are primarily engaged in the
business of acquiring mortgages and other liens on and interests in real estate
("Qualifying Interests"). Under the current interpretation of the staff of the
Securities and Exchange Commission (the "SEC'), we must maintain at least 55% of
our assets directly in Qualifying Interests in order to qualify for this
exemption. We closely monitor our compliance with this requirement and we intend
to maintain our exempt status. We have been able to maintain our exemption so
far through the purchase of whole pool U.S. Government agency and privately
issued ARM securities and loans that qualify for the exemption. See "Portfolio
of Mortgage Assets - Pass-Through Certificates - Privately Issued ARM
Pass-Through Certificates."

PORTFOLIO OF MORTGAGE ASSETS

As of December 31, 2001, ARM assets comprised approximately 99% of our total
assets. We have invested in the following types of mortgage assets in accordance
with the operating policies established by our Board of Directors and described
in "Business - Operating Policies and Strategies - Operating Restrictions."

PASS-THROUGH CERTIFICATES

Our investments in mortgage assets are concentrated in High Quality ARM
pass-through certificates, which account for approximately 79% of the ARM assets
that we hold. These certificates consist of U.S. Government agency and privately
issued ARM pass-through certificates that meet the High Quality credit criteria.
See "Operating Policies and Strategies - Investment Strategies." The High
Quality ARM pass-through certificates that we acquire represent interests in ARM
loans that are secured primarily by first liens on single-family (one-to-four
units) residential properties, although we may also acquire ARM pass-through
certificates secured by liens on other types of real estate-related properties.
We also include in this category of assets a portion of the ARM and Hybrid ARM
loans that have been deposited in a trust and held as collateral for our notes
payable in the amount equivalent to the "AAA" portion of the debt issued by the
trust.

The following is a discussion of each type of pass-through certificate that we
held as of December 31, 2001:

Freddie Mac ARM Programs

Freddie Mac is a shareholder-owned government sponsored enterprise created
pursuant to an Act of Congress on July 24, 1970. The principal activity of
Freddie Mac consists of the purchase of first lien, conventional residential
mortgages, including both whole loans and participation interests in such
mortgages and the resale of the loans and participations in the form of
guaranteed mortgage assets. Each Freddie Mac ARM Certificate issued to date has
been issued in the form of a pass-through certificate representing an undivided
interest in a pool of ARM loans purchased by Freddie Mac. The ARM loans included
in each pool are fully amortizing, conventional mortgage loans with original
terms to maturity of up to 40 years secured by first liens on one-to-four unit
family residential properties or multi-family properties. The interest rates
paid on Freddie Mac ARM Certificates adjust periodically on the first day of the
month following the month in which the interest rates on the underlying mortgage
loans adjust.

Freddie Mac guarantees to each holder of its ARM Certificates the timely payment
of interest at the applicable pass-through rate and the ultimate collection of
all principal on the holder's pro rata share of the unpaid principal balance of
the related ARM loans, but does not guarantee the timely payment of scheduled
principal of the underlying mortgage loans. The obligations of Freddie Mac under
its guarantees are solely those of Freddie Mac and are not backed by the full
faith and credit of the U.S. Government. If Freddie Mac were unable to satisfy
such obligations, distributions to holders of Freddie Mac ARM Certificates would
consist solely of payments and other recoveries on the underlying mortgage loans
and, accordingly, monthly distributions to holders of Freddie Mac ARM
Certificates would be affected by delinquent payments and defaults on such
mortgage loans.

Fannie Mae ARM Programs

Fannie Mae is a federally chartered and privately owned corporation organized
and existing under the Federal National Mortgage Association Charter Act. Fannie
Mae provides funds to the mortgage market primarily by purchasing home mortgage
loans from mortgage loan originators, thereby replenishing their funds for
additional lending. Fannie Mae

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established its first ARM programs in 1982 and currently has several ARM
programs under which ARM certificates may be issued, including programs for the
issuance of assets through REMICs under the Code. Each Fannie Mae ARM
Certificate issued to date has been issued in the form of a pass-through
certificate representing a fractional undivided interest in a pool of ARM loans
formed by Fannie Mae. The ARM loans included in each pool are fully amortizing
conventional mortgage loans secured by a first lien on either one-to-four family
residential properties or multi-family properties. The original term to maturity
of the mortgage loans generally does not exceed 40 years. Fannie Mae has issued
several different series of ARM Certificates. Each series bears an initial
interest rate and margin tied to an index based on all loans in the related
pool, less a fixed percentage representing servicing compensation and Fannie
Mae's guarantee fee.

Fannie Mae guarantees to the registered holder of a Fannie Mae ARM Certificate
that it will distribute amounts representing scheduled principal and interest
(at the rate provided by the Fannie Mae ARM Certificate) on the mortgage loans
in the pool underlying the Fannie Mae ARM Certificate, whether or not received,
and the full principal amount of any such mortgage loan foreclosed or otherwise
finally liquidated, whether or not the principal amount is actually received.
The obligations of Fannie Mae under its guarantees are solely those of Fannie
Mae and are not backed by the full faith and credit of the U.S. Government. If
Fannie Mae were unable to satisfy such obligations, distributions to holders of
Fannie Mae ARM Certificates would consist solely of payments and other
recoveries on the underlying mortgage loans and, accordingly, monthly
distributions to holders of Fannie Mae ARM Certificates would be affected by
delinquent payments and defaults on such mortgage loans.

Privately Issued ARM Pass-Through Certificates

Privately issued ARM pass-through certificates are structured similar to the
agency certificates discussed above but are issued by originators of, and
investors in, mortgage loans, including savings and loan associations, savings
banks, commercial banks, mortgage banks, investment banks and special purpose
subsidiaries of such institutions. Privately issued ARM pass-through
certificates are usually backed by a pool of conventional adjustable-rate
mortgage loans and are generally structured with one or more types of credit
enhancement, including pool insurance, guarantees, or subordination.
Accordingly, privately issued ARM pass-through certificates typically are not
guaranteed by an entity having the credit status of Freddie Mac or Fannie Mae.

Privately issued ARM pass-through certificates that are credit enhanced by
mortgage pool insurance provide us with an alternative source of ARM assets
(other than agency ARM assets) that meet the Qualifying Interests test for
purposes of maintaining our exemption under the Investment Company Act. However,
since many providers of mortgage pool insurance have stopped providing such
insurance, agency ARM securities and whole loans are currently our primary
sources of Qualifying Interests in real estate.

COLLATERALIZED MORTGAGE OBLIGATIONS ("CMOS"), MULTI-CLASS PASS-THROUGH ASSETS
AND COLLATERALIZED BOND OBLIGATIONS ("CBOS")

CMOs are debt obligations, ordinarily issued in series and most commonly backed
by a pool of fixed rate mortgage loans or pass-through certificates, each of
which consists of several serially maturing classes. Multi-class pass-through
securities are equity interests in a trust composed of similar underlying
mortgage assets. Generally, principal and interest payments received on the
underlying mortgage-related assets securing a series of CMOs or multi-class
pass-through securities are applied to principal and interest due on one or more
classes of the CMOs of such series or to pay scheduled distributions of
principal and interest on multi-class pass-throughs.

The CBOs that we acquire are debt obligations, but are secured by security
interests in portfolios of High Quality, low duration, mortgage-backed,
asset-backed and other fixed and floating rate securities managed by
third-parties. We only acquire CBOs that have portfolios that consist primarily
of either real estate qualifying assets or High Quality mortgage-backed
securities. In a CBO transaction, principal and interest payments are used to
pay current period interest and any excess is reinvested into the portfolio. The
amount of proceeds at maturity on the CBO classes that we own is generally
dependent upon the total rate of return performance of the underlying collateral
and can result in a final redemption value that is less than the face value of
the investment. CBOs typically do not amortize monthly; rather, they mature on a
specific maturity date.

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Scheduled payments of principal and interest on the mortgage-related assets and
other collateral securing a series of CMOs, CBOs or multi-class pass-throughs
are intended to be sufficient to make timely payments of principal and interest
on such issues or securities and to retire each class of such obligations at
their stated maturity.

The multi-class pass-through securities that we own are backed by ARM assets or
ARM loans and are typically structured into classes designated as senior
classes, mezzanine classes and subordinated classes. We also own variable rate
classes of CMOs and CBOs that are backed by both fixed- and adjustable-rate
mortgages that are issued by Freddie Mac, Fannie Mae and other private issuers.

The senior classes in a multi-class pass-through security generally have first
priority over all cash flows and consequently have the least amount of credit
risk since principal losses are generally covered by mortgage pool insurance
policies or are charged against the subordinated classes in order of
subordination. As a result of these features, the senior classes receive the
highest credit rating from Rating Agencies of the series of classes for each
multi-class pass-through security.

The mezzanine classes of a multi-class pass-through security generally have a
slightly greater risk of principal loss than the senior classes since they
provide some credit enhancement to the senior classes. In most instances,
mezzanine classes participate on a pro-rata basis with senior classes in their
right to receive cash flow and have expected lives similar to the senior
classes. In other instances, mezzanine classes are subordinate in their right to
receive cash flow and have average lives that are longer than the senior
classes. However, in all cases, a mezzanine class has a similar or slightly
lower credit rating than the senior class from the Rating Agencies. Generally,
the mezzanine classes that we have acquired are rated High Quality.

Subordinated classes are junior in the right to receive payment from the
underlying mortgages to other classes of a multi-class pass-through security.
The subordination provides credit enhancement to the senior and mezzanine
classes. Subordinated classes may be at risk for some payment failures on the
mortgage loans securing or underlying such assets and generally represent a
greater level of credit risk as they are responsible for bearing the risk of
credit loss on all of the outstanding loans underlying a CMO, CBO or multi-class
pass-through. As a result of being subject to more credit risk, subordinated
classes generally have lower credit ratings relative to the senior and mezzanine
classes.

The subordinated classes that we have acquired were all rated at least
Investment Grade at the time of purchase by one of the Rating Agencies, and in
certain cases are High Quality, or were created as part of our process of
securitizing whole loans. The subordinated classes we have acquired in the open
market are limited in amount and bear yields that we believe are commensurate
with the increased risks involved. In general, we acquire subordinated classes
after they have been issued for some time (or are "seasoned") and when the more
senior classes of the multi-class security have been paid down to levels that
mitigate the risk of nonpayment on the subordinated classes.

The market for subordinated classes is not extensive and at times may be
illiquid. In addition, our ability to sell subordinated classes is limited by
the REIT provisions of the Code. We have not purchased any subordinated classes
that are not Qualified REIT Assets. The subordinated classes that we acquire
which are not High Quality, together with our other investments in Other
Investment assets, may not, in the aggregate, comprise more than 30% of our
total assets, in accordance with our investment policy.

The variable rate classes of CMOs and CBOs that we own generally float at a
spread to the one-month LIBOR index and are backed by mortgages that are either
fixed-rate or are adjustable-rate mortgages indexed to the one-year U. S.
Treasury yield or a Cost of Funds index.

ARM AND HYBRID ARM LOANS

When acquiring ARM and Hybrid ARM loans, we focus our attention on the key
aspects of a borrower's profile and the characteristics of a mortgage loan
product that we believe are most important in insuring excellent loan
performance and minimal credit exposure. Our loan programs generally focus on
larger down payments, borrowers with adequate liquid asset reserves, job
stability, excellent credit (as measured by a credit report and a credit score)
and a conservative appraisal process. The ARM and Hybrid ARM loans that we have
acquired are all first mortgages on single-family residential properties. Some
have additional collateral in the form of pledged financial assets. We acquire
loans that are generally underwritten to "A" quality standards. We consider
loans to be "A" quality when they are underwritten so as to assure that the
borrower has

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adequate verified income to make the required loan payment, adequate verified
equity in the underlying property, adequate liquid asset reserves, job stability
and is willing and able to repay the mortgage as demonstrated by an excellent
credit history. As a result, the loans that we acquire are generally fully
documented loans, generally with 80% or lower effective loan-to-property-value
ratios based on independently appraised property values, or are seasoned loans
with good payment history. The average effective loan-to-value ratio of our
loans averaged 66.2% as of December 31, 2001.

If an ARM or Hybrid ARM loan acquired has a loan-to-property-value that is above
80%, then we require the borrower to pay for private mortgage insurance
providing additional protection to us against credit risk. We only acquire loans
with original maturities of forty years or less. The ARM and Hybrid ARM loans
are either fully amortizing or are interest only, generally up to ten years, and
fully amortizing thereafter. All ARM loans that we acquire bear an interest rate
that is tied to an interest rate index. Some loans have periodic and lifetime
constraints on how much the loan interest rate can change on any predetermined
interest rate reset date. In general, the interest rate on each ARM loan resets
at a frequency that is either monthly, semi-annually or annually. The ARM loans
generally adjust based upon the following indices: a U.S. Treasury Bill index, a
LIBOR index, a Certificate of Deposit index, a Cost of Funds index or Prime Rate
index. The Hybrid ARM loans have an initial fixed rate period, generally 3 to 10
years, and then convert to an ARM loan with the features of an ARM loan
described above.

RISK FACTORS

FORWARD-LOOKING STATEMENTS

In accordance with the Private Securities Litigation Reform Act of 1995 (the
"1995 Act"), we can 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 in the forward-looking statements. Statements that are not
historical facts, including statements about our beliefs or expectations, are
forward-looking statements. The words "believe," "anticipate," "intend," "aim,"
"expect," "will," 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. Readers should
understand that many factors govern whether any forward-looking statement will
be or can be achieved. Any one of those factors could cause actual results to
differ materially from those projected.

The following is a summary of the risk factors that we currently believe are
important and that could cause our results to differ from expectations. Readers
should not construe such factors as exhaustive or as an admission regarding the
adequacy of any disclosure that we made prior to the effective date of the 1995
Act.

IF THE INTEREST PAYMENTS ON OUR BORROWINGS INCREASE RELATIVE TO THE INTEREST WE
EARN ON OUR ARM ASSETS, IT MAY ADVERSELY AFFECT OUR PROFITABILITY.

We earn money based upon the spread between the interest payments that we earn
on the ARM assets in our investment portfolio and the interest payments that we
must make on our borrowings. If the interest payments on our borrowings increase
relative to the interest we earn on our ARM assets, our profitability may be
adversely affected.

DIFFERENCES IN TIMING OF INTEREST RATE ADJUSTMENTS ON OUR ARM ASSETS AND OUR
BORROWINGS MAY ADVERSELY AFFECT OUR PROFITABILITY.

The ARM assets that we acquire have adjustable or variable rates. This means
that their interest rates may change over time based upon changes in an
objective interest rate index, such as:

o London Interbank Offered Rate ("LIBOR"). The interest rate that
banks in London offer for deposits in London of U.S. dollars.

o Treasury Index. An annual, monthly or weekly average yield of
benchmark U.S. Treasury securities, as published by the Federal
Reserve Board.

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o CD Rate. The weekly average of secondary market interest rates on
six-month negotiable certificates of deposit, as published by the
Federal Reserve Board.

o Cost of Funds. The actual cost of funds of savings institutions,
as reported by the Office of Thrift Supervision.

Accordingly, if short term interest rates increase, this may adversely affect
our profitability because the interest rates on our borrowings generally adjust
more frequently than the interest rates on our ARM assets.

INTEREST RATE CHANGES WILL AFFECT OUR ARM ASSETS AND BORROWINGS DIFFERENTLY
WHICH MAY ADVERSELY AFFECT OUR PROFITABILITY.

Interest rate changes may also impact our ARM assets and borrowings differently
because our ARM assets are indexed to various indices whereas the interest rates
on our borrowings generally move with changes in LIBOR. Although we have always
favored acquiring LIBOR-based ARM assets in order to reduce this risk,
LIBOR-based ARMs are not generally well accepted by homeowners in the U.S. As a
result, we have acquired ARM assets indexed to a mix of indices in order to
diversify our exposure to changes in LIBOR in contrast to changes in other
indices. During times of global economic instability, U.S. Treasury rates
generally decline because foreign and domestic investors generally consider U.S.
Treasury instruments to be a safe haven for investments. Our ARM assets indexed
to U.S. Treasury rates then decline in yield as U.S. Treasury rates decline,
whereas our borrowings and other ARM assets may not be affected by the same
pressures or to the same degree. As a result, our income can improve or decrease
depending on the relationship between the various indices that our ARM assets
are indexed to compared to changes in our cost of funds.

INTEREST RATE CAPS ON OUR ARM ASSETS MAY ADVERSELY AFFECT OUR PROFITABILITY.

Our ARM assets are typically subject to periodic and lifetime interest rate
caps. Periodic interest rate caps limit the amount by which an interest rate can
increase during any given period. Lifetime interest rate caps limit the amount
by which an interest rate can increase through maturity of an ARM asset. Our
borrowings are not subject to similar restrictions. Accordingly, in a period of
rapidly increasing interest rates, we could experience a decrease in net income
or a net loss because the interest rates on our borrowings could increase
without limitation while the interest rates on our ARM assets would be limited
by caps. In order to mitigate the risks from lifetime interest rate caps, we
purchase interest rate cap agreements that result in our receiving cash payments
if the interest rate indices specified in the cap agreements exceed certain
levels.

OUR USE OF HEDGING STRATEGIES TO MITIGATE OUR INTEREST RATE AND PREPAYMENT RISKS
MAY NOT BE EFFECTIVE.

Our policies permit us to enter into interest rate swaps, caps and floors and
other derivative transactions to help us mitigate the interest rate risks
described above. However, no hedging strategy can completely insulate us from
risk. Furthermore, certain of the federal income tax requirements that we must
satisfy to qualify as a REIT limit our ability to hedge against such risks. We
will not enter into hedging transactions if we believe they will jeopardize our
status as a REIT. In addition, we do not use a hedging strategy with respect to
the final year of the fixed term of our hybrid ARM assets, which may expose us
to additional risk in periods of rising interest rates.

AN INCREASE IN PREPAYMENT RATES MAY ADVERSELY AFFECT OUR PROFITABILITY.

We have purchased ARM securities that have a higher interest rate than the
market interest rate at the time of purchase. In exchange for this higher
interest rate, we must pay a premium over the outstanding balance to acquire the
ARM asset. In accordance with accounting rules, we amortize this premium over
the term of the ARM asset. If the ARM asset is prepaid in whole or in part prior
to its expected life, we must amortize the premium at a faster rate, resulting
in a reduced yield on our ARM assets. This adversely affects our profitability.

Prepayment rates generally increase when interest rates fall and decrease when
interest rates rise, but changes in prepayment rates are difficult to predict.
Prepayment rates also may be affected by conditions in the housing and financial
markets, general economic conditions and the relative interest rates on
fixed-rate and adjustable-rate mortgage loans.

15

Additionally, when interest rates decline and higher interest rate ARM assets
are prepaid, we may not be able to reinvest the proceeds in ARM assets that have
comparable yields, which could also adversely affect our profitability.

While we seek to minimize prepayment risk to the greatest extent practical, in
selecting investments we must balance prepayment risk against other risks and
the potential returns of each investment. No strategy can completely insulate us
from prepayment risk.

AN INCREASE IN INTEREST RATES MAY ADVERSELY AFFECT OUR BOOK VALUE.

Increases in interest rates may negatively affect the market value of our ARM
assets. In accordance with accounting rules, we reduce our book value by the
amount of any decrease in the market value of our ARM securities and we disclose
the fair value of our ARM loans in the footnotes to our financial statements.

OUR STRATEGY INVOLVES LEVERAGE.

We seek to maintain an equity-to-assets ratio of between 8% and 10%, based on
historical costs. We incur this leverage by borrowing against a substantial
portion of the market value of our ARM assets. By incurring this leverage, we
expect to enhance our returns. However, this leverage, which is fundamental to
our investment strategy, also creates risks, which are outlined below:

o OUR LEVERAGE MAY CAUSE SUBSTANTIAL LOSSES.

Because of our leverage, we may incur substantial losses if our
borrowing costs increase dramatically. Our borrowing costs may increase for
various reasons, including but not limited to the following:

o short-term interest rates increase;

o the market value of our ARM assets decreases;

o interest rate volatility increases; or

o the availability of financing in the market decreases.

o OUR LEVERAGE MAY MAGNIFY THE IMPACT OF MARGIN CALLS, REDUCING OUR
LIQUIDITY, AND RESULT IN DEFAULTS OR FORCE US TO SELL ASSETS UNDER
ADVERSE MARKET CONDITIONS.

A decline in the value of our ARM assets may result in our lenders
initiating margin calls. A margin call means that the lender requires us to
pledge additional collateral to re-establish the ratio of the value of the
collateral to the amount of the borrowing. If we are unable to satisfy margin
calls, our lenders may foreclose on our collateral. This could force us to sell
our ARM assets under adverse market conditions. Additionally, in the event of
bankruptcy, our borrowings, which are generally made under repurchase
agreements, may qualify for special treatment under the Bankruptcy Code. This
special treatment would allow the lenders under these agreements to avoid the
automatic stay provisions of the Bankruptcy Code and to liquidate the collateral
under these agreements without delay.

o LIQUIDATION OF COLLATERAL MAY JEOPARDIZE OUR REIT STATUS.

To continue to qualify as a REIT, we must comply with requirements
regarding our assets and our sources of income. If we are compelled to liquidate
our ARM assets, we may be unable to comply with these requirements, ultimately
jeopardizing our status as a REIT. For further discussion of these asset and
source of income requirements and the consequences of our failure to continue to
qualify as a REIT, please see the "Federal Income Tax Considerations" section of
this report.

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o WE MAY NOT BE ABLE TO ACHIEVE OUR OPTIMAL LEVERAGE.

We use leverage as a strategy to increase the return to our investors.
However, we may not be able to achieve our desired leverage for various reasons,
including but not limited to the following:

o we determine that the leverage would expose us to excessive
risk;

o our lenders do not make funding available to us at
acceptable rates; or

o our lenders require that we provide additional collateral to
cover our borrowings.

o WE MAY INCUR INCREASED BORROWING COSTS WHICH WOULD ADVERSELY AFFECT
OUR PROFITABILITY.

Most of our borrowings are collateralized borrowings in the form of
reverse repurchase agreements. If the interest rates on these reverse repurchase
agreements increase, it would adversely affect our profitability, particularly
in the short term.

Our borrowing costs under reverse repurchase agreements generally
correspond to short term interest rates such as LIBOR, plus or minus a margin.
The margins on these borrowings over or under short term interest rates may vary
for various reasons, including but not limited to the following:

o the movement of interest rates;

o the availability of financing in the market; or o the value
and liquidity of our ARM assets.

IF WE ARE UNABLE TO BORROW AT FAVORABLE RATES, OUR PROFITABILITY MAY BE
ADVERSELY AFFECTED.

Since we rely primarily on short-term borrowings, our ability to achieve our
investment objectives depends not only on our ability to borrow money in
sufficient amounts and on favorable terms, but also on our ability to renew or
replace on a continuous basis our maturing short term borrowings. If we are not
able to renew or replace maturing borrowings on favorable terms, we would have
to sell our assets under possibly adverse market conditions.

OUR INVESTMENT STRATEGY OF ACQUIRING, ACCUMULATING AND SECURITIZING ARM LOANS
INVOLVES CREDIT RISK.

We bear the risk of loss on any ARM loans that we acquire or originate. We have
acquired ARM loans which are not credit enhanced and which do not have the
backing of Fannie Mae or Freddie Mac with the intention of securitizing such
loans into high quality assets. Accordingly, we will be subject to risks of
borrower default, bankruptcy and special hazard losses (such as those occurring
from earthquakes) to the extent that there is any deficiency between the value
of the mortgage collateral and insurance and the principal amount of the ARM
loan. In the event of a default on any such loans that we hold, we would bear
the loss of principal between the value of the mortgaged property and the
outstanding indebtedness, as well as the loss of interest. We intend to
securitize the ARM loans that we acquire to achieve better financing rates and
to improve our access to financing. We expect, however, to retain some credit
risk, as well as risks of bankruptcy and special hazard losses, in order to
facilitate the creation of high quality ARM securities for our portfolio.

OUR RECENT EXPANSION INTO NEW LINES OF BUSINESS MAY NOT BE SUCCESSFUL.

Our recent expansion into mortgage loan origination through TMHL represents a
new line of business for us and therefore, we cannot guarantee that we will be
successful. We are attempting to mitigate the high fixed costs generally
associated with such activity by using (1) private label, fee-based, third party
vendors who specialize in the underwriting, processing and closing of mortgage
loans, and (2) a subservicer to provide the capability to service the loans that
we originate or purchase. We are dependent upon the availability and quality of
the performance of such third party providers and we cannot guarantee that they
will successfully perform the services for which we engage them.

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WE HAVE NOT ESTABLISHED A MINIMUM DIVIDEND PAYMENT LEVEL.

We intend to pay quarterly dividends and to make distributions to our
shareholders in amounts such that all or substantially all of our taxable income
in each year (subject to certain adjustments) is distributed. This will enable
us to qualify for the tax benefits accorded to a REIT under the Code. We have
not established a minimum dividend payment level and our ability to pay
dividends may be adversely affected for the reasons described in this section.
All distributions will be made at the discretion of our Board of Directors and
will depend on our earnings, our financial condition, the maintenance of our
REIT status and such other factors as our Board of Directors may deem relevant
from time to time.

BECAUSE OF COMPETITION, WE MAY NOT BE ABLE TO ACQUIRE ARM ASSETS AT FAVORABLE
YIELDS.

Our net income depends, in large part, on our ability to acquire ARM assets at
favorable spreads over our borrowing costs. In acquiring ARM assets, we compete
with other REITs, investment banking firms, savings and loan associations,
banks, insurance companies, mutual funds, other lenders and other entities that
purchase ARM assets, many of which have greater financial resources than us. As
a result, in the future, we may not be able to acquire sufficient ARM assets at
favorable spreads over our borrowing costs.

WE ARE DEPENDENT ON OUR KEY PERSONNEL.

We are dependent on the efforts of our key officers and employees, including
Garrett Thornburg, Chairman of the Board of Directors and Chief Executive
Officer; Larry Goldstone, President and Chief Operating Officer; Richard P.
Story, Executive Vice President, Chief Financial Officer and Treasurer; and
Joseph H. Badal, Executive Vice President of Single Family Residential Lending.
The loss of any of their services could have an adverse effect on our
operations.

SOME OF OUR DIRECTORS AND OFFICERS HAVE OWNERSHIP INTERESTS IN AN AFFILIATE THAT
CREATE POTENTIAL CONFLICTS OF INTEREST.

Mr. Thornburg, our Chairman and Chief Executive Officer, and several of our
other directors and officers, have direct and indirect ownership interests in an
affiliate that create potential conflicts of interest. Mr. Thornburg is Chairman
of the Board, Chief Executive Officer and a director of the Manager and owns a
controlling interest in the Manager. Mr. Goldstone, our President and Chief
Operating Officer and one of our directors, is a managing director of the
Manager. Mr. Story, our Executive Vice President, Treasurer and Chief Financial
Officer and one of our directors, is a managing director and the Chief
Accounting Officer of the Manager. Mr. Badal, our Executive Vice President of
Single Family Residential Lending and one of our directors, is a managing
director of the Manager. As such, Mr. Thornburg, Mr. Goldstone, Mr. Story and
Mr. Badal are paid employees of the Manager. Mr. Goldstone, Mr. Story and Mr.
Badal own minority interests in the Manager.

Under our Management Agreement, the Manager is entitled to earn certain
incentive compensation based on the level of our annualized net income. In
evaluating mortgage assets for investment and with respect to other management
strategies, an undue emphasis on the maximization of income at the expense of
other criteria could result in increased risk to the value of our portfolio.

WE AND OUR SHAREHOLDERS ARE SUBJECT TO CERTAIN TAX RISKS.

o OUR FAILURE TO QUALIFY AS A REIT WOULD HAVE ADVERSE CONSEQUENCES ON
THE AMOUNT OF CASH AVAILABLE FOR DIVIDEND DISTRIBUTIONS.

Since 1993, we have qualified for taxation as a REIT for federal income
tax purposes. We plan to continue to meet the requirements for taxation as a
REIT. Many of these requirements, however, are highly technical and complex. The
determination that we are a REIT requires an analysis of various factual matters
and circumstances that may not be totally within our control. For example, to
qualify as a REIT, at least 75% of our assets must be Qualified REIT Assets
(which include mortgage loans, ARM securities and other MBS that we acquire),
government securities, cash and cash items. In addition at least 75% of our
gross income must come from real estate sources and 95% of our gross income must
come from real estate sources and certain other sources, mainly interest and
dividends. We are also required to distribute to shareholders at least 90% of
our REIT taxable income (excluding capital gains). Even a technical or
inadvertent mistake could jeopardize our REIT status. Furthermore, Congress and
the Internal Revenue Service (the "Service") might make changes to the tax laws

18

and regulations, and the courts might issue new rulings, that make it more
difficult or impossible for us to remain qualified as a REIT.

If we fail to qualify as a REIT, we would be subject to federal income
tax at regular corporate rates. Also, unless the Service granted us relief under
certain statutory provisions, we would remain disqualified as a REIT for four
years following the year in which we first fail to qualify. If we fail to
qualify as a REIT, we would have to pay significant income taxes and would
therefore have less money available for investments or for distributions to our
shareholders. This would likely have a significant adverse effect on the value
of our stock. In addition, the tax law would no longer require us to make
distributions to our shareholders.

o WE HAVE CERTAIN DISTRIBUTION REQUIREMENTS.

As a REIT, we must distribute 90% of our annual taxable income in
dividends to our shareholders. The required distribution limits the amount that
we have available for other business purposes, including amounts to fund our
growth. It is also possible that because of the differences between the time
during which we actually receive revenue or pay expenses and the period during
which we report those items for distribution purposes, we may have to borrow
funds on a short term basis to meet the 90% distribution requirement. In most
circumstances, we expect to distribute all of our taxable income in order to
avoid any corporate level tax.

o WE ARE ALSO SUBJECT TO OTHER TAX LIABILITIES.

Even if we qualify as a REIT, we may be subject to certain federal,
state and local taxes on our income and property. Any of these taxes would
reduce our operating cash flow.

THE LOSS OF THE INVESTMENT COMPANY ACT EXEMPTION WOULD ADVERSELY AFFECT US.

We intend to conduct our business so as not to become regulated as an investment
company under the Investment Company Act. If we fail to qualify for this
exemption, our ability to use leverage would be substantially reduced and we
would be unable to conduct our business as described in this prospectus.

The Investment Company Act exempts entities that are primarily engaged in the
business of purchasing or otherwise acquiring mortgages and other liens on and
interests in real estate. Under the current interpretation of the SEC staff, in
order to qualify for this exemption, we must maintain at least 55% of our assets
directly in these qualifying real estate interests. ARM securities that do not
represent all of the certificates issued with respect to an underlying pool of
mortgages may be treated as securities separate from the underlying mortgage
loans and, thus, may not qualify for purposes of the 55% requirement. Therefore,
our ownership of such ARM securities is limited by the provisions of the
Investment Company Act. In addition, in meeting the 55% requirement under the
Investment Company Act, we treat as qualifying interests ARM securities issued
with respect to an underlying pool as to which we hold the issued certificates
that represent the entire economic interest in the underlying mortgage pool. If
the SEC or its staff adopts a contrary interpretation of such treatment, we
could be required to sell a substantial amount of our ARM securities under
potentially adverse market conditions. Further, in order to insure that we at
all times qualify for the exemption from the Investment Company Act, we may be
precluded from acquiring ARM securities whose yield is higher than the yield on
ARM securities that could be purchased in a manner consistent with the
exemption. The net effect of these factors may be to lower our net income.

ISSUANCES OF LARGE AMOUNTS OF OUR STOCK COULD CAUSE OUR PRICE TO DECLINE.

We may, from time to time, issue additional shares of common stock or shares of
preferred stock that are convertible into common stock, as well as issue
warrants to purchase common stock or convertible preferred stock. If we issue a
significant number of shares of common stock or convertible preferred stock, or
if warrant holders exercise their warrants in a short period of time, dilution
of our outstanding common stock and an accompanying decrease in the market price
of our common stock could occur.

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WE MAY CHANGE OUR POLICIES WITHOUT SHAREHOLDER APPROVAL.

Our Board of Directors establishes all of our fundamental operating
policies, including our investment, financing and distribution policies, and any
revisions in such policies requires the approval of the Board of Directors.
Although the Board has no current plans to do so, it may amend or revise these
policies at any time without a vote of our shareholders. Policy changes could
adversely affect our financial condition, results of operations, the market
price of our common stock or our ability to pay dividends or distributions.

COMPETITION

In acquiring ARM assets, we compete with other mortgage REITs, investment
banking firms, savings and loan associations, banks, mortgage bankers, insurance
companies, mutual funds, lenders, Fannie Mae, Freddie Mac and other entities
purchasing ARM assets, many of which have greater financial resources than we
do. The existence of such entities may increase the competition for the
acquisition of ARM assets resulting in higher prices and lower yields on such
mortgage assets.

EMPLOYEES

As of December 31, 2001, we had no employees. The Manager carries out our
day-to-day operations, subject to the supervision of our Board of Directors and
under the terms of the Management Agreement discussed below.

THE MANAGEMENT AGREEMENT

We entered into the Management Agreement with the Manager for a ten year term,
with an annual review required each year. If we terminate the Management
Agreement other than for cause, we must pay the Manager a minimum fee. The
Management Agreement also provides that in the event a person or entity obtains
more than 20% of our common stock, if we are combined with another entity, or if
we terminate the Management Agreement other than for cause, we are obligated to
acquire substantially all of the Manager's assets through an exchange of shares
with a value based on a formula tied to the Manager's net profits. We have the
right to terminate the Management Agreement upon the occurrence of certain
specific events, including a material breach by the Manager of any provision
contained in the Management Agreement.

The Manager at all times is subject to the supervision of our Board of Directors
and has only such functions and authority as we may delegate to it. The Manager
is responsible for our day-to-day operations and performs such services and
activities relating to our assets and operations as may be appropriate. In
addition, our wholly owned subsidiaries have entered into separate management
agreements with the Manager for additional management services.

The Manager receives a per annum base management fee on a declining scale based
on average shareholders' equity, adjusted for liabilities that are not incurred
to finance assets ("Average Shareholders' Equity" or "Average Net Invested
Assets" as defined in the Management Agreement), payable monthly in arrears. The
base management fee formula is subject to an annual increase based on any
increase in the Consumer Price Index over the previous twelve-month period. The
Manager is also entitled to receive, as incentive compensation for each fiscal
quarter, an amount equal to 20% of our Net Income (as defined in the Management
Agreement), before incentive compensation, in excess of the amount that would
produce an annualized return on equity equal to 1% over the Ten Year U.S.
Treasury Rate. The Management Agreement also requires us to reimburse the
Manager for expenses that it incurs related to acquiring, securitizing, selling,
hedging, and servicing our portfolio of ARM loans. For further information
regarding the base management fee, incentive compensation reimbursable expenses
and applicable definitions, see our Proxy Statement dated March 27, 2002 under
the caption "Certain Relationships and Related Transactions."

Subject to the limitations set forth below, we pay all our operating expenses
except those that the Manager is specifically required to pay under the
Management Agreement. The operating expenses that the Manager is required to pay
include the compensation of our personnel who are performing management services
for the Manager and the cost of office space, equipment and other personnel
required for the management of our day-to-day operations. The expenses that we
are required to pay include costs incident to the acquisition, disposition,
securitization and financing of mortgage loans, the compensation and expenses of
our operating personnel, regular legal and auditing fees and expenses, the fees
and expenses of our directors, the costs of printing and mailing proxies and
reports to shareholders, the fees and expenses of our custodian and transfer
agent, if any, and the reimbursement of any obligation of the Manager for any
New Mexico Gross Receipts Tax liability. The

20

expenses that we are required to pay, which are attributable to our operations,
are limited to an amount per year equal to the greater of 2% of our Average Net
Invested Assets or 25% of our Net Income for that year. The determination of Net
Income for purposes of calculating the expense limitation is the same as for
calculating the Manager's incentive compensation except that it includes any
incentive compensation payable for such period. The Manager must pay expenses in
excess of such amount, unless the unaffiliated directors determine that, based
upon unusual or non-recurring factors, a higher level of expenses is justified
for such fiscal year. In that event, the Manager may recover such expenses in
succeeding years to the extent that expenses in succeeding quarters are below
the limitation of expenses. We are also required to pay expenses associated with
litigation and other extraordinary or non-recurring expenses. Expense
reimbursement is made monthly, subject to adjustment at the end of each year.

Expenses excluded from the expense limitation are those incurred in connection
with the servicing of mortgage loans, the raising of capital, the acquisition
and disposition of assets, interest expenses, taxes and license fees, non-cash
costs and the incentive management fee.

FEDERAL INCOME TAX CONSIDERATIONS

GENERAL

We have elected to be treated as a REIT for federal income tax purposes. In
brief, if we meet certain detailed conditions imposed by the REIT provisions of
the Code, such as investing primarily in real estate and mortgage loans, we will
not be taxed at the corporate level on the taxable income that we currently
distribute to our shareholders. We can therefore avoid most of the "double
taxation" (at the corporate level and then again at the shareholder level when
the income is distributed) that we would otherwise experience if we were a
corporation.

If we do not qualify as a REIT in any given year, we would be subject to federal
income tax as a domestic corporation, which would reduce the amount of the
after-tax cash available for distribution to our shareholders. We believe that
we have satisfied the requirements for qualification as a REIT since the year
ended 1993. We intend at all times to continue to comply with the requirements
for qualification as a REIT under the Code, as described below.

REQUIREMENTS FOR QUALIFICATION AS A REIT

To qualify for tax treatment as a REIT under the Code, we must meet certain
tests, as described briefly below.

Ownership of Common Stock

For all taxable years after the first taxable year for which we elected to be a
REIT, a minimum of 100 persons must hold our shares of capital stock for at
least 335 days of a 12 month year (or a proportionate part of a short tax year).
In addition, at all times during the second half of each taxable year, no more
than 50% in value of our capital stock may be owned directly or indirectly by
five or fewer individuals. We are required to maintain records regarding the
ownership of our shares and to demand statements from persons who own more than
a certain number of our shares regarding their ownership of shares. We must keep
a list of those shareholders who fail to reply to such a demand.

We are required to use the calendar year as our taxable year for income tax
purposes.

Nature of Assets

On the last day of each calendar quarter, at least 75% of the value of our
assets must consist of Qualified REIT Assets, government assets, cash and cash
items. We expect that substantially all of our assets will continue to be
Qualified REIT Assets. On the last day of each calendar quarter, of the assets
not included in the foregoing 75% assets test, the value of securities that we
hold issued by any one issuer may not exceed 5% in value of our total assets and
we may not own more than 10% of any one issuer's outstanding securities (with an
exception for a qualified electing taxable REIT subsidiary or a qualified REIT
subsidiary). Under that exception, the aggregate value of businesses that we may
undertake through taxable subsidiaries is limited to 20% or less of our total
assets. We monitor the purchase and holding of our assets in order to comply
with the above asset tests.

21

We may from time to time hold, through one or more taxable REIT subsidiaries,
assets that, if we held directly, could otherwise generate income that would
have an adverse effect on our qualification as a REIT or on certain classes of
our shareholders. We do not reasonably expect that the value of such taxable
subsidiaries, in the aggregate, will ever exceed 20% of our assets.

Sources of Income

We must meet the following separate income-based tests each year:

1. THE 75% TEST. At least 75% of our gross income for the taxable year must
be derived from Qualified REIT Assets including interest (other than interest
based in whole or in part on the income or profits of any person) on obligations
secured by mortgages on real property or interests in real property. The
investments that we have made and will continue to make will give rise primarily
to mortgage interest qualifying under the 75% income test.

2. THE 95% TEST. In addition to deriving 75% of our gross income from the
sources listed above, at least an additional 20% of our gross income for the
taxable year must be derived from those sources, or from dividends, interest or
gains from the sale or disposition of stock or other assets that are not dealer
property. We intend to limit substantially all of the assets that we acquire
(other than stock in certain affiliate corporations as discussed below) to
Qualified REIT Assets. Our policy to maintain REIT status may limit the type of
assets, including hedging contracts and other assets, that we otherwise might
acquire.

Distributions

We must distribute to our shareholders on a pro rata basis each year an amount
equal to at least (i) 90% of our taxable income before deduction of dividends
paid and excluding net capital gain, plus (ii) 90% of the excess of the net
income from foreclosure property over the tax imposed on such income by the
Code, less (iii) any "excess noncash income". We intend to make distributions to
our shareholders in sufficient amounts to meet the distribution requirement.

The Service has ruled that if a REIT's dividend reinvestment plan (the "DRP")
allows shareholders of the REIT to elect to have cash distributions reinvested
in shares of the REIT at a purchase price equal to at least 95% of fair market
value on the distribution date, then such cash distributions qualify under the
95% distribution test. We believe that our DRP complies with this ruling.

TAXATION OF SHAREHOLDERS

For any taxable year in which we are treated as a REIT for federal income
purposes, the amounts that we distribute to our shareholders out of current or
accumulated earnings and profits will be includable by the shareholders as
ordinary income for federal income tax purposes unless properly designated by
the Company as capital gain dividends. Our distributions will not be eligible
for the dividends received deduction for corporations. Shareholders may not
deduct any of our net operating losses or capital losses.

If we make distributions to our shareholders in excess of our current and
accumulated earnings and profits, those distributions will be considered first a
tax-free return of capital, reducing the tax basis of a shareholder's shares
until the tax basis is zero. Such distributions in excess of the tax basis will
be taxable as gain realized from the sale of our shares. We will withhold 30% of
dividend distributions to shareholders that we know to be foreign persons unless
the shareholder provides us with a properly completed IRS form for claiming the
reduced withholding rate under an applicable income tax treaty.

The provisions of the Code are highly technical and complex. This summary is not
intended to be a detailed discussion of the Code or its rules and regulations,
or of related administrative and judicial interpretations. We have not obtained
a ruling from the Internal Revenue Service with respect to tax considerations
relevant to our organization or operation, or to an acquisition of our common
stock. This summary is not intended to be a substitute for prudent tax planning
and each of our shareholders is urged to consult its own tax advisor with
respect to these and other federal, state and local tax consequences of the
acquisition, ownership and disposition of shares of our stock and any potential
changes in applicable law.

22

TAXATION OF THE COMPANY

We are subject to corporate-level taxation on any undistributed income. In
addition, we face corporate level taxation on the failure to make timely
distributions, on the built-in gain on assets acquired from a taxable
corporation such as a taxable REIT subsidiary, on the income from any property
for which we take in foreclosure and make a foreclosure property election, and
on the gain from any property that is treated as "dealer property" in our hands.

ITEM 2. PROPERTIES

Our principal executive offices are located in Santa Fe, New Mexico
and are provided by the Manager in accordance with the Management
Agreement. Our subsidiaries have their principal offices in Santa Fe,
New Mexico and are leased from the Manager.

ITEM 3. LEGAL PROCEEDINGS

At December 31, 2001, there were no pending legal proceedings to
which we were a party or to which any of our property was subject.

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

No matters were submitted to a vote of our shareholders during the
fourth quarter of 2001.

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PART II

ITEM 5. MARKET FOR COMMON EQUITY AND RELATED SHAREHOLDER MATTERS

Our common stock is traded on the New York Stock Exchange under the trading
symbol "TMA". As of February 22, 2002, we had 39,255,366 shares of common stock
outstanding, held by 1,927 holders of record and approximately 34,700 beneficial
owners.

The following table sets forth, for the periods indicated, the high, low and
closing sales prices per share of our common stock as reported on the New York
Stock Exchange composite tape and the cash dividends declared per share of
common stock.

- ----------------
(1) The fourth quarter of 2001 dividend was declared in December 2001 and paid
in January 2002.

(2) The fourth quarter of 2000 dividend was declared in January 2001 and paid in
February 2001.

In order to qualify for the tax benefits accorded to a REIT under the Code, we
intend to pay quarterly dividends such that all or substantially all of our
taxable income each year (subject to certain adjustments) is distributed to our
shareholders. All of the distributions that we make will be at the discretion of
our Board of Directors and will depend on our earnings and financial condition,
maintenance of REIT status and any other factors that the Board of Directors
deems relevant.

DIVIDEND REINVESTMENT PLAN

We have a Dividend Reinvestment and Stock Purchase Plan (the "DRP") that allows
both common and preferred shareholders to reinvest their dividends in, and to
purchase, additional shares of our common stock. At our discretion, shareholders
may purchase common stock under the DRP directly from us at a discount from the
then prevailing market price or in the open market. Shareholders and
non-shareholders may also make additional monthly purchases of stock, subject to
a minimum of $100 ($500 for non-shareholders) and a maximum of $5,000 for each
optional cash purchase. American Stock Transfer & Trust Company, our transfer
agent (the "Agent"), is the trustee and administrator of the DRP. Shareholders
who own stock that is registered in their own name and want to participate in
the DRP must deliver a completed enrollment form to the Agent. Shareholders who
own stock that is registered in a name other than their own (e.g., broker or
bank nominee) and want to participate in the DRP must either request the broker
or nominee to participate on their behalf or request that the broker or nominee
re-register the stock in the shareholder's name and deliver a completed
enrollment form to the Agent. Additional information about the DRP (including a
prospectus) and forms are available from the Agent or us.

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ITEM 6. SELECTED FINANCIAL DATA

The following selected financial data are derived from our audited financial
statements for the years ended December 31, 2001, 2000, 1999, 1998 and 1997. You
should read the selected financial data together with the more detailed
information contained in the Financial Statements and associated Notes and
"Management's Discussion and Analysis of Financial Conditions and Results of
Operations" included elsewhere in this Form 10-K (Amounts in thousands, except
per share data).

OPERATIONS STATEMENT HIGHLIGHTS

BALANCE SHEET HIGHLIGHTS

- -----------------
(1) For the applicable year as reported in the Company's quarterly earnings
announcements.

(2) Before unrealized market value adjustments.

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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

CRITICAL ACCOUNTING POLICIES

The Company's 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 Securities and Exchange Commission
guidance, those material accounting policies that we believe are the most
critical to an investor's understanding of the Company's financial results and
condition and require complex management judgment have been expanded and
discussed below.

o Fair Value. The Company records its ARM securities and Cap and Swap
Agreements at fair value. The fair values of the Company's ARM securities
and Cap and Swap Agreements 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 is not
reasonably available from a dealer or a third-party pricing service,
management estimates the fair value based on characteristics of the
security it receives from the issuer and available market information. The
fair values reported reflect estimates and may not necessarily be
indicative of the amounts the Company could realize in a current market
exchange.

o Basis Adjustments on ARM Securities and Loss Allowances on ARM Loans. The
Company, in general, securitizes all of its loans and retains the resulting
securities in its ARM portfolio. At the time of securitization, the Company
obtains a credit review of the loans being securitized by one or more of
the Rating Agencies. Based on this review, a determination is made
regarding the expected losses to be realized in the future and the Company
adjusts the basis of the securities to their expected realizable value.
This is referred to as a "basis adjustment." In doing so, the Company
establishes an account, similar to a loss reserve, to absorb the expected
credit losses. The Company then monitors the delinquencies and losses on
the underlying mortgage loans backing its ARM securities. If the credit
performance of the underlying mortgage loans is not as expected, the
Company makes a provision for additional probable credit losses at a level
deemed appropriate by management to provide for known losses as well as
estimated losses inherent in its ARM securities portfolio. Any such
provision is based on management's assessment of numerous factors affecting
its portfolio of ARM assets including, but not limited to, current economic
conditions, delinquency status, credit losses to date on underlying
mortgages and remaining credit protection. The basis adjustment for ARM
securities is made by reducing the cost basis of the individual security
for the decline in fair value, which is other than temporary, and the
amount of such write-down is recorded as a realized loss, thereby reducing
earnings.

Prior to November 2001, the Company made a monthly provision for estimated
credit losses on its portfolio of ARM loans, which is an increase to the
allowance for loan losses. The Company recorded a provision for estimated
loan losses in the amount of $513,000 during 2001. In November 2001, the
Company made the determination that virtually all of its loans were
expected to be securitized and that none of its loans were expected to
experience a loss prior to securitization. Therefore, the Company
discontinued recording a provision for estimated loan losses during the
fourth quarter of 2001. The Company will continue to evaluate its estimated
credit losses on loans that are not expected to be securitized and for
estimated credit losses that become probable prior to securitization.

o Loan Securitization. The Company securitizes loans for its ARM securities
portfolio. The Company does not sell any of the securities created from
this securitization process, but rather retains all of the beneficial and
economic interests of the loans. The securitizations of the Company's loans
are not accounted for as sales and the Company does not record any
servicing assets or liabilities as a result of this process.

o Revenue Recognition. Interest income on ARM assets is a combination of
accruing interest based on the outstanding balance and their contractual
terms and the amortization of yield adjustments using generally accepted
interest methods, principally the amortization of purchase premiums and
discounts. The Company amortizes purchase premiums and discounts utilizing
an estimate of the remaining life of the ARM assets based on actual
prepayment experience and the impact of the current applicable indexes to
the expected interest rates over the remaining life of the ARM assets.

For additional information on the Company's significant accounting policies, see
Note 1 to the Consolidated Financial Statements.

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FINANCIAL CONDITION

At December 31, 2001, the Company held total assets of $5.804 billion, $5.733
billion of which consisted of ARM assets. That compares to $4.190 billion in
total assets and $4.139 billion of ARM assets at December 31, 2000. Since
commencing operations, the Company has purchased either ARM securities (backed
by agencies of the U.S. government or privately-issued, generally publicly
registered, mortgage assets, most of which are rated AA or higher by at least
one of the Rating Agencies) or ARM loans generally originated to "A" quality
underwriting standards. At December 31, 2001, 96.0% of the assets held by the
Company, including cash and cash equivalents, were High Quality assets, far
exceeding the Company's investment policy minimum requirement of investing at
least 70% of its total assets in High Quality ARM assets and cash and cash
equivalents. Of the ARM assets owned by the Company as of December 31, 2002,
81.1% are in the form of adjustable-rate pass-through certificates or ARM loans.
The remainder are floating rate classes of CMOs (11.1%), short-term fixed-rate
classes of CMOs (4.8%) or investments in floating rate classes of CBOs (3.0%)
backed primarily by ARM mortgaged-backed securities.

The following table presents a schedule of ARM assets owned at December 31, 2001
and December 31, 2000 classified by High Quality and Other Investment assets and
further classified by type of issuer and by ratings categories.

ARM ASSETS BY ISSUER AND CREDIT RATING
(Dollar amounts in thousands)

- -----------------
(1) The AAA Rating category includes $442.2 million and $615.7 million of
whole loans as of December 31, 2001 and 2000, respectively, that have
been credit enhanced to AAA by a combination of an insurance policy
purchased from a third-party and an unrated subordinated certificate
retained by the Company in the amount of $31.8 and $32.0 million as of
December 31, 2001 and 2000, respectively. The subordinated certificate
is included in the BB/Ba Rating and Other category.

As of December 31, 2001 and 2000, the Company had reduced the cost basis of its
securitized ARM loans by $7,925,000 and $635,000, respectively, due to estimated
credit losses (other than temporary declines in fair value). In addition, the
Company had reduced the cost basis of other ARM securities by $1,151,000 and
$1,234,000, as of the same dates, respectively, related to Other Investments
that the Company purchased at a discount that included an estimate of credit
losses.

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As of December 31, 2001, the Company's ARM loan portfolio, inclusive of
securitized loans, included 9 delinquent loans (60 days or more delinquent) with
an aggregate balance of $1,632,000. The ARM loan portfolio, inclusive of
securitized loans, also includes two properties ("REO") that the Company
acquired as the result of foreclosure processes in the amount of $289,000. The
average original effective loan-to-value ratio on the 9 delinquent loans and REO
is approximately 75%. The Company believes that its current level of basis
adjustments and reserves, is adequate to cover estimated losses from these loans
and REO properties.

The following table presents a summary of the Company's basis adjustments on the
Company's securitized ARM loans, basis adjustments on other ARM securities and
the Company's allowance for losses on ARM loans (dollar amounts in thousands):

The following table classifies the Company's portfolio of ARM and short-term
mortgage assets by type of interest rate index.

ARM AND SHORT-TERM MORTGAGE ASSETS BY INDEX
(Dollar amounts in thousands)

The ARM portfolio had a current weighted average coupon of 5.96% at December 31,
2001. This consisted of an average coupon of 6.26% on the hybrid portion of the
portfolio and an average coupon of 5.71% on the rest of the portfolio. If the
non-hybrid portion of the portfolio had been "fully indexed," the weighted
average coupon of the ARM portfolio would have been approximately 5.16%, 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 that is
currently equal to its applicable index plus a margin to the index that is
specified by the terms of the ARM asset.

28

As of December 31, 2000, the ARM portfolio had a weighted average c