THORNBURG MORTGAGE INC - 10-Q Quarterly Report

Back to GetFilings.com

================================================================================

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

FORM 10-Q

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

FOR THE QUARTERLY PERIOD ENDED: SEPTEMBER 30, 2002

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 (IRS Employer
incorporation or organization) Identification Number)

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

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

(Former name, former address and former fiscal year,
if changed since last report)
Not applicable

Indicate by check mark whether the Registrant (1) has filed all documents and
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.

(1) Yes X No
--------- ---------
(2) Yes X No
--------- ---------

APPLICABLE ONLY TO CORPORATE ISSUERS:

Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the last practicable date.

Common Stock ($.01 par value) 49,754,356 as of November 11, 2002

THORNBURG MORTGAGE, INC.
FORM 10-Q

INDEX

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

THORNBURG MORTGAGE, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS
(Amounts in thousands)

See Notes to Consolidated Financial Statements.

3

THORNBURG MORTGAGE, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
(In thousands, except per share data)

(a) Basic and diluted earnings per share were reduced by $0.01 in the first
nine months of 2001 due to the impact of the adoption of FAS 133 relating
to the accounting for derivative instruments and hedging activities.

See Notes to Consolidated Financial Statements.

4

THORNBURG MORTGAGE, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (UNAUDITED)
Nine months ended September 30, 2002 and 2001
(In thousands, except share data)

See Notes to Consolidated Financial Statements.

5

THORNBURG MORTGAGE, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(In thousands)

Supplemental disclosure of cash flow information and non-cash activities are
included in Note 4.

See Notes to Consolidated Financial Statements

6

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1. SIGNIFICANT ACCOUNTING POLICIES

The accompanying unaudited consolidated financial statements have been
prepared in accordance with generally accepted accounting principles for
interim financial information and with the instructions to Form 10-Q and
Rule 10-01 of Regulation S-X. Therefore, they do not include all of the
information and footnotes required by generally accepted accounting
principles for complete financial statements.

In the opinion of management, all material adjustments, consisting of
normal recurring adjustments, considered necessary for a fair presentation
have been included. The operating results for the quarter and nine months
ended September 30, 2002 are not necessarily indicative of the results that
may be expected for the calendar year ending December 31, 2002.

BASIS OF PRESENTATION AND PRINCIPLES OF CONSOLIDATION

The consolidated financial statements include the accounts of
Thornburg Mortgage, Inc. (together with its subsidiaries referred
to hereafter as the "Company") and its two wholly-owned
bankruptcy-remote special purpose finance subsidiaries, Thornburg
Mortgage Funding Corporation ("TMFC") and Thornburg Mortgage
Acceptance Corporation ("TMAC"), its wholly-owned mortgage
banking subsidiary, Thornburg Mortgage Home Loans, Inc. ("TMHL"),
and TMHL's two wholly-owned special purpose finance subsidiaries,
Thornburg Mortgage Funding Corporation II and Thornburg Mortgage
Acceptance Corporation II. As of January 1, 2002, all of the
Company's subsidiaries are wholly owned qualified REIT
subsidiaries and are consolidated with the Company for financial
statement and tax reporting purposes. All material intercompany
accounts and transactions are eliminated in consolidation.
Certain reclassifications have been made to prior years' amounts
to conform with current year classifications.

CASH AND CASH EQUIVALENTS

Cash and cash equivalents includes cash on hand and highly liquid
investments with original maturities of three months or less. The
carrying amount of cash equivalents approximates their fair
value.

ADJUSTABLE-RATE MORTGAGE ASSETS

The Company's adjustable-rate mortgage ("ARM") assets are
comprised of ARM securities, ARM loans and collateral for AAA
notes payable, which also consists of ARM securities and ARM
loans. Included in the Company's ARM assets are hybrid ARM
securities and loans ("Hybrid ARMs") that have a fixed interest
rate for an initial period, generally three to ten years, and
then convert to an adjustable rate for their remaining term to
maturity.

Management has designated all of the Company's ARM securities as
available-for-sale. Therefore, they are reported at fair value,
with unrealized gains and losses reported in "Accumulated other
comprehensive income (loss)" as a separate component of
shareholders' equity.

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 capitalize any servicing rights or obligations as a
result of this process. The fair value reflected in the Company's
financial statements for these securities is based on market
prices provided by certain dealers who make markets in these
financial instruments.

7

In general, ARM assets have a maximum lifetime interest rate cap,
or ceiling, meaning that individual ARM assets contain a
contractual maximum interest rate ("Life Cap"). ARM securities
typically have a Life Cap that not only places a constraint on
the ability of an ARM security to adjust to higher interest
rates, but also affects the changes in fair value of an ARM
security. In addition, interest rates on non-hybrid ARM assets
are generally limited to an increase of either 1% or 2% per
adjustment period ("Periodic Cap"). Hybrid ARMs generally have a
higher initial Periodic Cap, up to 6%, that is applicable at the
end of their fixed interest rate period and they are generally
subject to a typical non-hybrid Periodic Cap thereafter.

Management has the intent and ability to hold the Company's ARM
loans for the foreseeable future and until maturity or payoff.
Therefore, they are carried at their unpaid principal balances,
net of unamortized premium or discount and allowance for loan
losses.

The collateral for the AAA notes includes ARM securities and ARM
loans, which are accounted for in the same manner as the ARM
securities and ARM loans that are not held as collateral.

Interest income on ARM assets is accrued based on the outstanding
principal amount and their contractual terms. Premiums and
discounts associated with the purchase of the ARM assets are
amortized into interest income over the lives of the assets using
the effective yield method adjusted for the effects of estimated
prepayments.

ARM asset transactions are recorded on the date the ARM assets
are purchased or sold. Purchases of new issue ARM securities and
all ARM loans are recorded when all significant uncertainties
regarding the characteristics of the assets are removed and, in
the case of loans, underwriting due diligence has been completed,
generally shortly before the settlement date. Realized gains and
losses on ARM asset transactions are determined on the specific
identification basis.

CREDIT RISK

The Company limits its exposure to credit losses on its portfolio
of ARM securities by only purchasing ARM securities that have an
investment grade rating at the time of purchase and have some
form of credit enhancement or are guaranteed by an agency of the
federal government, ("Ginnie Mae") or a federally chartered
corporation ("Fannie Mae" or "Freddie Mac".) An investment grade
security generally has a security rating of BBB or Baa or better
by at least one of two nationally recognized rating agencies,
Standard & Poor's, Inc. or Moody's Investor Services, Inc. (the
"Rating Agencies"). Additionally, the Company also purchases and
originates ARM loans and limits its exposure to credit losses by
restricting its whole loan purchases and originations to ARM
loans generally originated to "A" quality underwriting standards
or, in the case of purchased whole loans, to loans that have at
least five years of pay history and/or low loan to property value
ratios. The Company further limits its exposure to credit risk by
limiting its investment in investment grade securities that are
rated A, or equivalent, BBB, or equivalent, or ARM loans
originated to "A" quality underwriting standards ("Other
Investments") to no more than 30% of the portfolio, including the
subordinate classes of securities retained as part of the
Company's securitization of 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 by one or
more Rating Agencies of the loans being securitized. Based on
this review, the Company makes a determination regarding the
expected losses to be realized in the future and adjusts the
basis of the securities to their expected realizable value. In
doing so, the Company establishes a basis adjustment amount 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 good 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. The
provision is based on management's assessment of numerous factors

8

affecting the Company's 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 provision 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. Additionally, once a loan within one of these
securities is 90 days or more delinquent or a borrower declares
bankruptcy, the Company adjusts the value of its accrued interest
receivable to what it believes to be collectible and stops
accruing interest on that portion of the security collateralized
by the loan.

In addition, credit losses on pools of loans held as collateral
for AAA notes payable are also covered by third-party insurance
policies that protect the Company from credit losses above a
specified level, limiting the Company's exposure to credit losses
on such loans. The Company reduces the cost basis of the
subordinated security retained at the time the collateralized
notes payable are issued to take into consideration estimated
credit losses on the underlying loans.

Loans that are not yet securitized are also reviewed for probable
losses. The Company's loans are held for securitization, which
generally occurs within a few months of acquisition or
origination. As a result, although the Company reviews its
unsecuritized loans for probable losses, it is unlikely a loan
would incur a loss prior to securitization. If a loss were
estimated on an unsecuritized loan, the Company would record a
provision, which would reduce earnings, and establish a loan loss
reserve.

Provisions for credit losses do not reduce taxable income and
thus do not affect the dividends paid by the Company to
shareholders in the period the provisions are taken. Actual
losses realized by the Company do reduce taxable income in the
period the actual loss is realized and would affect the dividends
paid to shareholders for that tax year.

VALUATION METHODS

The fair values of the Company's ARM securities 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 that the Company receives from the issuer and
available market information. The fair values for ARM loans are
estimated by the Company by using the same pricing models
employed by the Company in the process of determining a price to
bid for loans in the open market, taking into consideration the
aggregated characteristics of groups of loans such as, but not
limited to, collateral type, index, margin, life cap, periodic
cap, underwriting standards, age and credit. The fair value of
the Company's collateralized notes payable, interest rate swap
agreements and interest rate cap agreements is based on market
values provided by dealers who are familiar with the terms of the
notes, swap agreements and cap agreements. The fair values
reported reflect estimates and may not necessarily be indicative
of the amounts the Company could realize in a current market
exchange. Cash and cash equivalents, interest receivable, reverse
repurchase agreements, other borrowings and other liabilities are
reflected in the financial statements at their amortized cost,
which approximates their fair value because of the short-term
nature of these instruments.

DERIVATIVE FINANCIAL INSTRUMENTS

All of the Company's derivative financial instruments (interest
rate cap agreements, interest rate swap agreements and Eurodollar
futures contracts) are carried on the balance sheet at their fair
value. If a derivative is designated as a "fair value hedge", the
changes in the fair value of the derivative instrument and the
changes in the fair value of the hedged item are both recognized
in earnings. If a derivative is designated as a "cash flow hedge"
the effective amount of change in the fair value of the
derivative instrument is recorded in "Other comprehensive income"
and is transferred from "Other comprehensive income" to earnings
as the hedged item affects earnings. The ineffective amount of
all hedges is recognized in earnings each quarter.

9

As the Company enters into hedging transactions, it formally
documents the relationship between the hedging instruments and
the hedged items. The Company has also documented its
risk-management policies, including objectives and strategies, as
they relate to its hedging activities. The Company assesses, both
at inception of a hedging activity and on an on-going basis,
whether or not the hedging activity is highly effective. When it
is determined that a hedge is not highly effective, the Company
discontinues hedge accounting prospectively.

INTEREST RATE CAP AGREEMENTS

The Company purchases interest rate cap agreements ("Cap
Agreements") to manage interest rate risk on a portion of its
assets. In general, ARM assets have a Life Cap, which is a
component of the fair value of an ARM asset. Pursuant to the
terms of the Cap Agreements, the Company will receive cash
payments if the interest rate index specified in any such Cap
Agreement increases above certain specified levels. Therefore,
such Cap Agreements have the effect of offsetting a portion of
the Company's borrowing costs, thereby reducing the effect of the
lifetime cap feature on the Company's ARM assets so that the net
margin on the Company's ARM assets will be protected in high
interest rate environments. The Cap Agreements the Company has
purchased also have the effect of offsetting a portion of the
fair value change in the Company's ARM assets related to the Life
Cap.

The Company does not currently apply hedge accounting to its Cap
Agreements and, as a result, the Company records the change in
fair value of the Cap Agreements as hedging expense in current
earnings. The Company purchases Cap Agreements by incurring a
one-time fee or premium and carries them at fair value. The
carrying value of the Cap Agreements is included in "Prepaid
expenses and other" on the balance sheet.

INTEREST RATE SWAP AGREEMENTS AND EURODOLLAR FUTURES CONTRACTS

The Company enters into interest rate swap agreements ("Swap
Agreements") and Eurodollar futures contracts ("Eurodollar
Transactions") in order to manage its interest rate exposure when
financing its ARM assets. The Company generally borrows money
based on short-term interest rates, either by entering into
borrowings with maturity terms of less than one year, and
frequently one to three months, or by entering into borrowings
with longer maturities of one to two years that have an interest
rate that is reset based on a frequency that is commonly one to
three months. The Company's ARM assets generally have an interest
rate that reprices based on frequency terms of one to twelve
months. The Company's Hybrid ARMs have an initial fixed interest
rate period of three to ten years. As a result, the Company's
existing and forecasted borrowings reprice to a new rate on a
more frequent basis than do the Company's ARM assets. When the
Company enters into a Swap Agreement, it generally agrees to pay
a fixed rate of interest and to receive a variable interest rate,
generally based on LIBOR. The Company also enters into Eurodollar
Transactions in order to hedge changes in its forecasted
three-month LIBOR based liabilities. The notional balances of the
Swap Agreements and the total contract size of the Eurodollar
Transactions generally decline over the life of these
instruments. These Swap Agreements and Eurodollar Transactions
have the effect of converting the Company's variable-rate debt
into fixed-rate debt over the life of the Swap Agreements and
Eurodollar Transactions. These instruments are used as a cost
effective way to lengthen the average repricing period of the
Company's variable rate and short-term borrowings such that the
average repricing of the borrowings more closely matches the
average repricing of the Company's ARM assets.

All Swap Agreements are designated as cash flow hedges against
the interest rate risk associated with the Company's borrowings.
Although the terms and characteristics of the Company's Swap
Agreements and hedged borrowings are nearly identical, due to the
explicit requirements of FAS 133, the Company does not account
for these hedges under a method defined in FAS 133 as the
"shortcut" method, but rather the Company calculates the
effectiveness of these hedges on an ongoing basis, and to date,
has calculated effectiveness of approximately 100%. Eurodollar
Transactions are also designated as cash flow hedges and are
accounted for in accordance with

10

FAS 133 implementation issue No. G7, Method 1: Change in Variable
Cash Flow Method, and application of this method has resulted in
no measured ineffectiveness. All changes in the unrealized gains
and losses on Swap Agreements and the Eurodollar Transactions
have been recorded in "Other comprehensive income" and are
reclassified to earnings as interest expense is recognized on the
Company's hedged borrowings. If it becomes probable that the
forecasted transaction, which in this case refers to interest
payments to be made under the Company's short-term borrowing
agreements, will not occur by the end of the originally specified
time period, as documented at the inception of the hedging
relationship, or within an additional two-month time period
thereafter, then the related gain or loss in "Other comprehensive
income" would be reclassified to income. As of September 30,
2002, the net unrealized loss on Swap Agreements, deferred gains
from terminated Swap Agreements and deferred gains and losses on
Eurodollar Transactions recorded in "Other comprehensive income"
was a net loss of $125.5 million. The Company estimates that over
the next twelve months, approximately $60.9 million of these net
unrealized losses will be reclassified from "Other comprehensive
income" to earnings.

The loss on Swap Agreements is the discounted value of the
remaining future net interest payments expected to be made over
the remaining life of the Swap Agreements. Therefore, over time,
as the actual payments are made, the unrealized loss in "Other
comprehensive income" and the carrying value of the Swap
Agreements adjusts to zero and the Company realizes a fixed cost
of money over the life of the hedging instrument. The carrying
value of the Swap Agreements, in the amount of $124.1 million as
of September 30, 2002, is included in "Reverse repurchase
agreements" in the accompanying balance sheets.

The Company has terminated and replaced Swap Agreements as an
additional source of liquidity when it was able to do so while
maintaining compliance with its hedging policies. Since the
Company's adoption of FAS 133, realized gains and losses
resulting from the termination of Swap Agreements are initially
recorded in "Other comprehensive income" as a separate component
of equity. The gain or loss from the terminated Swap Agreements
remains in "Other comprehensive income" until the forecasted
interest payments affect earnings. If it becomes probable that
the forecasted interest payments will not occur, then the entire
gain or loss would be reclassified to earnings.

INCOME TAXES

The Company elected to be taxed as a Real Estate Investment Trust
("REIT") and believes it complies with the provisions of the
Internal Revenue Code of 1986, as amended (the "Code") with
respect thereto. Accordingly, the Company will not be subject to
Federal income tax on that portion of its income that is
distributed to shareholders, as long as certain asset, income and
stock ownership tests are met. During 2001, TMHL and each of its
subsidiaries were taxable REIT subsidiaries and, as such, were
subject to both federal and state corporate income tax. As of
January 1, 2002, the Company revoked its election to operate TMHL
and its subsidiaries as taxable REIT subsidiaries and as a result
they are now qualified REIT subsidiaries.

11

NET EARNINGS PER SHARE

Basic EPS amounts are computed by dividing net income (adjusted
for dividends declared on preferred stock) by the weighted
average number of common shares outstanding. Diluted EPS amounts
assume the conversion, exercise or issuance of all potential
common stock instruments, unless the effect is to reduce a loss
or increase the earnings per common share. Following is
information about the computation of the earnings per share data
for the three- and nine-month periods ended September 30, 2002
and 2001 (amounts in thousands except per share data):

The Company did not grant any options to purchase shares of
common stock during the nine-month period ended September 30,
2002. The Company did grant 35,666 options to purchase common
stock to directors and officers of the Company at an average
price of $10.56 per share during the nine months ended
September 30, 2001. As of September 30, 2002, all of the
previously granted options to purchase shares of common stock
had either been exercised, cancelled or had expired.

USE OF ESTIMATES

The preparation of financial statements in conformity with
generally accepted accounting principles requires management
to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent
assets and liabilities at the date of the financial statements
and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those
estimates.

13

NOTE 2. ADJUSTABLE-RATE MORTGAGE ASSETS

The following tables present the Company's ARM assets as of
September 30, 2002 and December 31, 2001. The ARM securities
classified as available-for-sale are carried at their fair value,
while the ARM loans are carried at their amortized cost basis
(dollar amounts in thousands):

September 30, 2002:

December 31, 2001:

During the nine-month period ended September 30, 2002, the
Company sold $72.9 million of ARM securities for a gain of
$113,000. The ARM securities sold were classified as
available-for-sale. In addition, the Company sold $4.1 million of
loans during the first nine months of 2002 and realized a gross
gain of $6,000 and a gross loss of $14,000. During the nine-month
period ended September 30, 2001, the Company sold $108.1 million
of ARM securities and realized $244,000 in gains and $245,000 in
losses. In addition, the Company sold $0.3 million of fixed-rate
loans that it originated during the first nine months of 2001 for
a gain of $2,000.

During the nine-month period ended September 30, 2002, the
Company securitized $1.477 billion of its ARM loans into a series
of privately-issued multi-class ARM securities. The Company
retained, for its ARM portfolio, all of the classes of the
securities created. The Company did not account for any of these
securitizations as sales and, therefore, did not record any gain
or loss in connection with the securitizations. As of September
30, 2002, the Company had $2.706 billion of ARM assets that have
resulted from the Company's securitization efforts.

14

As of September 30, 2002 and December 31, 2001, the Company had
reduced the cost basis of its securitized ARM loans by
$11,687,000 and $7,925,000, respectively, due to estimated credit
losses (other than temporary declines in fair value). The
reduction in the cost basis recorded during the nine months of
2002, in the amount of $3,762,000, was recorded in connection
with the Company's securitization of the $1.477 billion of loans.

As of September 30, 2002 and December 31, 2001, the Company had
reduced the cost basis of other ARM securities by $856,000 and
$1,151,000, respectively, due to estimated credit losses (other
than temporary declines in fair value). The estimated credit
losses for these ARM securities relate to Other Investments that
the Company purchased at a discount that included an estimate of
credit losses. During the nine-month period ended September 30,
2002, the Company recorded realized losses on these ARM
securities in the amount of $460,000 and realized recoveries in
the amount of $165,000 and, in accordance with its credit
policies, the Company did not provide for any additional
estimated credit losses.

The following tables summarize ARM loan delinquency information
as of September 30, 2002 and December 31, 2001 (dollar amounts in
thousands):

September 30, 2002

December 31, 2001

(1) ARM loans includes loans held for securitization and
loans that the Company has securitized and retained
first loss credit exposure for total amounts of $3.227
billion and $1.924 billion at September 30, 2002 and
December 31, 2001, respectively.

As of September 30, 2002, the Company also owned two real estate
properties as a result of foreclosing on delinquent loans in the
aggregate amount of $506,000 (not included in the table above.)
The Company has a $100,000 reserve for estimated losses on these
properties. The Company believes that its current level of
reserves is adequate to cover any estimated loss, should one
occur, from the sale of these properties.

15

As of September 30, 2002, the Company had commitments to purchase
or originate the following amounts of ARM assets (dollar amounts
in thousands):

Freddie Mac/Fannie Mae ARM securities $ 211,956
Private high quality ARM securities 512,602
Whole loans - bulk purchase 103,947
Whole loans - correspondent 455,289
Whole loans - direct originations 221,546
-----------
$ 1,505,340
===========

During the nine months ended September 30, 2002, the Company
entered into two transactions whereby the Company expects to
acquire the remaining balance of certain AAA rated, Hybrid ARM
securities, at a price of par, in 2006 and 2007, when the
fixed-rate period of the Hybrid ARM securities terminates and they
convert into ARM securities that have characteristics similar to
the ARM securities held in the current portfolio and, therefore,
the Company views these as an alternative source of ARM assets.
The current balance of the Hybrid ARM securities is approximately
$2.56 billion, but is expected to be less than 25% of that, and
could be zero, at the time they convert into ARM securities. If
the Company decides not to acquire the Hybrid ARM securities when
they convert into ARM securities, then it is committed to pay or
receive the difference between par and the fair value of the ARM
securities at that time, as determined by an auction of the ARM
securities. As of September 30, 2002, the Company has delivered
$4.1 million of collateral in connection with these transactions.

NOTE 3. INTEREST RATE CAP AGREEMENTS

Included in "Prepaid expenses and other" are purchased Cap
Agreements with a remaining notional amount of $2.091 billion and
$2.254 billion as of September 30, 2002 and December 31, 2001,
respectively. The notional amount of the Cap Agreements purchased
declines at a rate that is expected to approximate the
amortization of the ARM securities. Under these Cap Agreements,
the Company will receive cash payments should the one-month or
three-month London InterBank Offer Rate ("LIBOR") increase above
the contract rates of these hedging instruments that range from
6.00% to 12.00% and average approximately 9.95%. The Cap
Agreements had an average maturity of 1.1 years as of September
30, 2002. The initial aggregate notional amount of the Cap
Agreements declines to approximately $2.041 billion over the
period of the agreements, which expire between 2002 and 2005.
During the three and nine-month periods ended September 30, 2002,
the Company recognized expenses of $173,000 and $1,109,000,
respectively, which is reported as "Hedging expense" in the
Company's Consolidated Statements of Operations.

The Company has credit risk to the extent that the counterparties
to the Cap Agreements do not perform their obligations under the
Cap Agreements. If one of the counterparties does not perform, the
Company would not receive the cash to which it would otherwise be
entitled under the conditions of the Cap Agreement. In order to
mitigate this risk and to achieve competitive pricing, the Company
has entered into Cap Agreements with six different counterparties,
five of which are rated AAA and one which is rated A (the Company
has a two-way collateral agreement protecting its credit exposure
with this counterparty.) The fair value of the Cap Agreements at
September 30, 2002 amounted to $233,000 and is included in
"Prepaid expenses and other" on the balance sheet.

NOTE 4. REVERSE REPURCHASE AGREEMENTS, COLLATERALIZED NOTES PAYABLE AND OTHER
BORROWINGS

The Company has arrangements to enter into reverse repurchase
agreements, a form of short-term borrowing, with 25 different
financial institutions and on September 30, 2002 had borrowed
funds from 14 of these firms. Because the Company borrows money
under these agreements based on the fair value of its ARM assets,
and because changes in interest rates can negatively impact the
valuation of ARM assets, the Company's borrowing ability under
these agreements could be limited and lenders could initiate
margin calls in the event interest rates change or the value of
the Company's ARM assets declines for other reasons.

16

As of September 30, 2002, the Company had $8.190 billion of
reverse repurchase agreements outstanding with a weighted average
borrowing rate of 1.97% and a weighted average remaining maturity
of 4.4 months. After including the $124.1 million carrying value
of Swap Agreements, the combined reverse repurchase agreements and
Swap Agreements outstanding of $8.314 billion as of September 30,
2002 had a weighted average borrowing rate of 3.17% and a weighted
average remaining maturity of 1.6 years. As of December 31, 2001,
the Company had $4.739 billion of reverse repurchase agreements
outstanding with a weighted average borrowing rate of 2.24% and a
weighted average remaining maturity of 2.8 months. As of September
30, 2002, $4.422 billion of the Company's borrowings were
variable-rate term reverse repurchase agreements with original
maturities that range from six months to eighteen months. The
interest rates of these term reverse repurchase agreements are
indexed to either the one- or three-month LIBOR rate and reprice
accordingly. ARM assets with a carrying value of $8.883 billion,
including accrued interest and cash totaling $25.7 million
collateralized the reverse repurchase agreements at September 30,
2002.

At September 30, 2002, the reverse repurchase agreements, which
includes the carrying value of Swap Agreements, had the following
remaining maturities (dollar amounts in thousands):

Within 30 days $ 3,063,458
31 to 89 days 1,468,418
90 to 365 days 3,552,277
Over 365 days 105,475
---------------
8,189,628
Swap Agreements (carrying value) 124,094
---------------
$ 8,313,722
===============

As of September 30, 2002, the Company had entered into three
whole loan financing facilities. Each of the whole loan financing
facilities has a committed borrowing capacity of $300 million.
One facility matures in March 2003 and the other two mature in
November 2002; the Company expects to renew the facilities
maturing in November. As of September 30, 2002, the Company had
$393.8 million borrowed against these whole loan financing
facilities at an effective cost of 2.43%. As of December 31,
2001, the Company had $37.7 million borrowed against whole loan
financing facilities at an effective cost of 2.53%. The amount
borrowed on the whole loan financing agreements at September 30,
2002 was collateralized by ARM loans with a carrying value of
$407.1 million, including accrued interest.

The whole loan financing facility with a borrowing capacity of
$300 million and maturing in March 2003, discussed above, is a
securitization transaction in which the Company transfers groups
of whole loans to a wholly-owned bankruptcy remote special
purpose subsidiary. The subsidiary, in turn, simultaneously
transfers its interest in the loans to a trust, which issues
beneficial interests in the loans in the form of a note and a
subordinated certificate. The note is then used to collateralize
borrowings. This whole loan financing facility works similarly to
a secured line of credit whereby the Company can deliver loans
into the facility and take loans out of the facility at the
Company's discretion. This securitization transaction is
accounted for as a secured borrowing.

On December 18, 1998, the Company, through a wholly-owned
bankruptcy remote special purpose finance subsidiary, issued
$1.144 billion of notes payable ("Notes") collateralized by ARM
loans and ARM securities. As part of this transaction, the
Company retained ownership of a subordinated certificate in the
amount of $32.4 million, which represents the Company's maximum
exposure to credit losses on the loans collateralizing the Notes.
As of September 30, 2002, the Notes had a net balance of $286.3
million and an effective interest cost of 2.53%, which changes
each month at a spread to one-month LIBOR. As of September 30,
2002, these Notes were collateralized by ARM loans with a
principal balance of $318.5 million. The Notes mature on January
25, 2029 and are callable by the Company at par once the total
balance of the loans collateralizing the Notes is reduced to 25%
of their original balance.

17

As of September 30, 2002, the Company was counterparty to
forty-six Swap Agreements and Eurodollar Transactions having an
aggregate current notional balance of $4.733 billion. In
addition, the Company also entered into a delayed Swap Agreement
with an aggregate notional balance of $500 million that becomes
effective in August 2003. These Swap Agreements and Eurodollar
Transactions hedge the cost of financing Hybrid ARMs during their
fixed rate term (generally three to ten years). The Company
limits the interest rate mismatch on the funding of its Hybrid
ARMs (the difference between the duration of the fixed-rate
period of Hybrid ARMs and the duration of the fixed-rate
liabilities) to a duration difference of no more than one year.
As of September 30, 2002, these Swap Agreements and Eurodollar
Transactions had a weighted average maturity of 2.8 years. In
accordance with the Swap Agreements, the Company will pay a fixed
rate of interest during the term of these Swap Agreements and
receive a payment that varies monthly with the one-month LIBOR
rate. As a result of entering into these Swap Agreements and
Eurodollar Transactions, the Company has reduced the interest
rate variability of its cost to finance its Hybrid ARM assets by
increasing the average period until the next repricing of its
borrowings that finance its Hybrid ARM assets from 40 days to 849
days. As of September 30, 2002, ARM assets with a carrying value
of $92.1 million (including accrued interest) and cash totaling
$12.1 million collateralized the Swap Agreements.

The total cash paid for interest was $63.8 million and $49.3
million during the quarters ended September 30, 2002 and 2001,
respectively.

NOTE 5. FAIR VALUE OF FINANCIAL INSTRUMENTS AND OFF-BALANCE SHEET CREDIT RISK

The following table presents the carrying amounts and estimated
fair values of the Company's financial instruments at September
30, 2002 and December 31, 2001 (dollar amounts in thousands):

The above Cap Agreements are included in the balance sheet under
the caption "Prepaid expenses and other." The carrying amount for
securities, which are categorized as available-for-sale, is their
fair value, whereas the carrying amount for loans, which are
categorized as held for the foreseeable future, is their
amortized cost.

NOTE 6. COMMON AND PREFERRED STOCK

During February 2002, the Company completed a public offering of
6,210,000 shares of common stock and received net proceeds of
$113.5 million under its shelf registration statement on Form S-3
that was declared effective by the Securities and Exchange
Commission ("SEC") on July 6, 2001. On August 30, 2002, a new
shelf registration statement on Form S-3 registering an
additional $400 million of equity securities was declared
effective by the SEC. During the three-month and nine-month
periods ended September 30, 2002, the Company issued 1,469,200
and 4,000,000 shares of common stock respectively, and received
net proceeds of $28.2 million and $76.5 million, respectively
under a continuous equity offering program under the July 2001
shelf registration statement. During the three months ended
September 30, 2002, the Company issued an additional 302,600
shares of common stock and received net proceeds of $5.7 million
under a new continuous equity offering program under the August
2002 shelf registration statement. As of September 3, 2002, $47.4
million and $394.2 million

18

of the Company's registered securities remained available for
future issuance and sale under its currently effective July 2001
and August 2002 shelf registration statements, respectively.

On June 26, 2002, the Company filed a Form S-3D to register an
additional 8,000,000 shares for issuance under the Dividend
Reinvestment and Stock Purchase Plan (the "DRP"). During the
three and nine-month periods ended September 30, 2002, the
Company issued 1,206,607 and 3,519,419 shares, respectively, of
common stock under the DRP and received net proceeds of $23.0
million and $68.9 million, respectively.

On June 14, 2002, the Company declared a second quarter dividend
of $0.605 per share to the shareholders of the Series A 9.68%
Cumulative Convertible Preferred Stock, which was paid on July
10, 2002 to preferred shareholders of record as of June 28, 2002.

On July 23, 2002, the Company declared a second quarter dividend
of $0.57 per common share, which was paid on August 16, 2002 to
common shareholders of record as of August 5, 2002.

On September 16, 2002, the Company declared a third quarter
dividend of $0.605 per share to the shareholders of the Series A
9.68% Cumulative Convertible Preferred Stock which was paid on
October 10, 2002 to preferred shareholders of record as of
September 30, 2002.

On October 21, 2002, the Company declared a third quarter
dividend of $0.58 per common share, which will be paid on
November 18, 2002 to common shareholders of record as of November
5, 2002.

For federal income tax purposes, all dividends are expected to be
ordinary income to the Company's common and preferred
shareholders, subject to year-end allocations of the common
dividend between ordinary income, capital gain income and
non-taxable income as return of capital, depending on the amount
and character of the Company's full year taxable income.

NOTE 7. STOCK OPTION PLAN

The Company's Board of Directors adopted the "2002 Long Term
Incentive Plan" (the "Plan"), effective September 29, 2002, which
has replaced the Company's previous Stock Option and Incentive
Plan that expired on September 28, 2002. The Plan is intended to
be a long-term incentive program. The Plan authorizes the
Compensation Committee to grant Incentive Options ("ISOs") as
defined under Section 422 of the Internal Revenue Code of 1986,
as amended, options not so qualified ("NQSOs"), Dividend
Equivalent Rights ("DERs"), Stock Appreciation Rights ("SARs")
and Phantom Stock Rights ("PSRs").

The present policy of the Compensation Committee and the Board is
to grant only PSR and DER awards under the Plan. The PSRs are
granted in lieu of stock options, based on equivalent values as
calculated by a Black Scholes option model. No stock options have
been granted under the Plan and there are no options outstanding
under either the Plan or the previous plan.

The PSRs, when received as a grant, generally vest over a
three-year period. DERs may be paid either in cash or in
additional PSRs, at the option of the recipient. The Company
usually issues DERs under a formula at the same time that other
awards under the Plan are granted. The DER and PSR participants
are allowed to elect to reinvest their PSR and DER cash dividends
into additional PSRs at the price of the Company's common stock
on the related dividend payment date. The PSRs are expensed over
the applicable vesting period. The DERs are fully expensed on the
Company's income statement.

Restricted shares of common stock had been granted under the
Company's previous Stock Option and Incentive Plan pursuant to
the direction of the Stock Option Committee (now renamed as the
Compensation Committee) and approval of the Board of Directors.
Restricted shares of common stock had generally been granted in
lieu of ISOs and NQSOs, based on equivalent values as calculated
by a Black Scholes option model. The Board of Directors
determined a vesting period for the restricted

19

shares granted (generally three years). In general, a portion of
the restricted shares vested at the end of each year of the
vesting period and the shares participated in the common
dividends declared during the vesting period. The Company
expenses the value of the restricted shares over the vesting
period, based on their value as of the date of grant. In April
2002, the Company's Board of Directors cancelled all previously
granted restricted shares of common stock and replaced them with
PSRs of equal value. The replacement PSRs vest over the original
vesting period of the cancelled restricted shares.

As of September 30, 2002, there were 1,094,566 DERs outstanding,
of which 1,066,405 were vested, and 372,808 PSRs outstanding, of
which 191,053 were vested. The Company recorded an expense
associated with DERs and PSRs of $718,000 and $296,000 for the
three-month periods ended September 30, 2002 and 2001,
respectively. During the nine-month periods ended September 30,
2002 and 2001, the Company recorded an expense associated with
DERs and PSRs in the amount of $2,198,000 and $818,000,
respectively. Of the expense recorded during the third quarter of
2002, $799,000 was the amount of dividend equivalents paid on
DERs and PSRs, $436,000 was the impact of the decrease in the
Company's common stock price on the value of the PSRs which was
recorded as a fair value adjustment, and $355,000 was the
amortization of unvested PSRs. As of September 30, 2002, all of
the previously issued ISOs and NQSOs had been exercised,
terminated or cancelled.

The Plan authorizes the granting of options to purchase an
aggregate of up to 1,800,000 shares, but not more than 5% of the
outstanding shares of the Company's common stock. Notes
receivable arise from the Company financing a portion of the
purchase of shares of common stock by directors and employees
through the exercise of stock options. The notes mature during
2010 and accrue interest at a rate of 3.91% per annum. In
addition, the notes are full recourse promissory notes and are
secured by a pledge of the shares of the common stock acquired.
Interest, which is credited to paid-in-capital, is payable
quarterly, with the balance due at the maturity of the notes. The
payment of the notes will be accelerated only upon the sale of
the shares of common stock pledged for the notes. The notes may
be prepaid at any time at the option of each borrower. As of
September 30, 2002, there was $7.6 million of notes receivable
outstanding from stock sales. All of these loans were made prior
to the enactment of the Sarbanes-Oxley Act of 2002. In April,
2002, the Board approved a limited stock repurchase program for
the repurchase at current market value of shares of common stock
that were acquired pursuant to the exercise of stock options
under the previous plan. The Company will first apply the
proceeds from any such repurchases to the repayment of any
outstanding stock option loans due from the holders. As of
September 30, 2002, no shares have been repurchased under this
program.

NOTE 8. TRANSACTIONS WITH AFFILIATES

The Company has a Management Agreement (the "Agreement") with
Thornburg Mortgage Advisory Corporation ("the Manager"). Under
the terms of the Agreement, the Manager, subject to the
supervision of the Company's Board of Directors, is responsible
for the management of the day-to-day operations of the Company
and provides certain personnel and office space. According to the
terms of the Agreement, certain defined expenses of the Manager
and affiliates of the Manager are reimbursed by the Company,
principally expenses of TMHL, the Company's mortgage banking
subsidiary, related to mortgage loan acquisition, selling,
servicing and securitization activities, including the personnel
and office space attributed to these activities. During the
quarters ended September 30, 2002 and 2001, the Company
reimbursed the Manager and affiliates of the Manager $696,000 and
$550,000 for expenses, respectively, in accordance with the terms
of the Agreement. During the nine-month periods ended September
30, 2002 and 2001, the Company reimbursed the Manager and
affiliates of the Manager $2,200,000 and $1,053,000 for expenses,
respectively. As of September 30, 2002 and 2001, $675,000 and
$158,000, respectively, was payable by the Company to the Manager
for these reimbursable expenses. The Agreement has a ten-year
term expiring July 15, 2009, and provides for an annual review of
the Manager's performance under the Agreement by the independent
directors of the Board of Directors. If the Company terminated
the Agreement for a reason other than for cause, a substantial
cancellation fee would be activated.

20

The Company pays the Manager an annual base management fee 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
Agreement), payable monthly in arrears as follows: 1.20% of the
first $300 million of Average Shareholders' Equity, plus 0.88% of
Average Shareholders' Equity above $300 million. The Agreement
also has a cost of living clause that adjusts the base management
fee formula by the change in the Consumer Price Index over the
previous twelve-month period, effective as of each annual review
of the Agreement. In addition, the three wholly-owned
subsidiaries of the Company and the two wholly-owned subsidiaries
of TMHL have entered into separate Management Agreements with the
Manager for additional management services for a combined amount
of $1,200 per month, paid in arrears.

For the quarters ended September 30, 2002 and 2001, the Company
incurred costs of $2,076,000 and $1,249,000, respectively, in
base management fees in accordance with the terms of the
Management Agreements. For the nine-month periods ended September
30, 2002 and 2001, the Company incurred base management fees of
$5,623,000 and $3,463,000, respectively. As of September 30, 2002
and 2001, $665,000 and $446,000, respectively, was payable by the
Company to the Manager for the base management fee.

The Manager is also entitled to earn performance-based
compensation in an amount equal to 20% of the Company's
annualized net income, before performance-based compensation,
above an annualized Return on Equity equal to the ten year U.S.
Treasury Rate plus 1%. For purposes of the performance fee
calculation, equity is generally defined as proceeds from
issuance of common stock before underwriter's discount and other
costs of issuance, plus retained earnings. For the three- and
nine-month periods ended September 30, 2002, the Manager earned
performance-based compensation in the amount of $5,044,000 and
$11,958,000, respectively. For the three- and nine-month periods
ended September 30, 2001, the Manager earned performance-based
compensation in the amount of $1,627,000 and $3,624,000,
respectively. As of September 30, 2002 and 2001, $5,044,000 and
$1,627,000, respectively, was payable by the Company to the
Manager for the incentive management fee.

Pursuant to an employee residential mortgage loan program
approved by the Board of Directors as part of the Company's
residential loan mortgage origination activities, certain of the
directors, officers and employees of the Company and of other
affiliates of the Company have obtained residential first lien
mortgage loans from the Company. In general, the terms of the
loans and the underwriting requirements are identical to the loan
programs that the Company offers to unaffiliated third parties,
except that participants in the program qualify for an employee
discount on the interest rate. At the time each participant
enters into a loan agreement, such participant executes an
addendum that provides for the discount on the interest rate that
is subject to cancellation at the time such participant's
employment is terminated for any reason. Effective with the
enactment of the Sarbanes-Oxley Act of 2002, on July 30, 2002,
any new loans made to directors or executive officers will not be
eligible for the employee discount. As of September 30, 2002, the
aggregate balance of mortgage loans outstanding to directors and
officers of the Company, employees of the Manager and other
affiliates amounted to $19.8 million, had a weighted average
interest rate of 5.101%, and maturities ranging between 2016 and
2032.

Effective January 1, 2002, TMHL entered into a Joint Marketing
Agreement with Thornburg Securities Corporation ("TSC"), a
registered broker-dealer. The initial term of the agreement
expires December 31, 2002, but shall continue thereafter for
successive three-month terms unless terminated by either party.
Under the terms of the agreement, TMHL shall pay TSC an annual
fee of $25,000, in quarterly installments, as compensation for
certain marketing, promotional and advertising services and to
provide marketing materials to brokers and financial advisers.
During the three and nine months ended September 30, 2002, TMHL
paid $18,750 to TSC pursuant to this agreement.

21

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS

Certain information contained in this Quarterly Report on Form 10-Q constitutes
"Forward-Looking Statements" within the meaning of Section 27A of the Securities
Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934,
as amended. You can identify such forward-looking statements by the presence of
forward-looking terminology such as "may," "will," "expect," "anticipate,"
"estimate," "plan," or "continue" or the negatives thereof or similar
terminology. You should be aware that all forward-looking statements involve
risks and uncertainties including, but not limited to, risks related to the
future level and relationship of various interest rates, prepayment rates,
availability and cost of acquiring new assets, the timing of new programs and
the performance of third party, private-label relationships involved in the
origination and servicing of loans. The cautionary statements that you will find
in the "Risk Factors" section on pages 14 through 20 of our 2001 Annual Report
on Form 10-K identify important factors, including certain risks and
uncertainties, with respect to such forward-looking statements that could cause
our actual results, performance or achievements to differ materially from those
reflected in such forward-looking statements.

MANAGEMENT'S DISCUSSION OF CORPORATE GOVERNANCE

In light of recent legislation and new regulations regarding Corporate
Governance, we would like to highlight our compliance with these new
requirements.

First of all, our Board of Directors consists of a majority of independent
directors. The Audit, Nominating and Compensation Committees of the Board of
Directors are also composed exclusively of independent directors.

Second, all of our long-term incentive compensation programs (which include the
granting of Phantom Stock Rights and Dividend Equivalent Rights) are fully
expensed in our statements of operations, and are fully disclosed in our
financial reports. Third, we have established a formal internal audit function
to further the effective functioning of our internal controls and procedures.
Our internal audit plan will provide management and the Audit Committee with an
effective tool to identify and address areas of financial or operational
concerns and ensure that appropriate controls and procedures are in place.

Finally, we have an Insider Trading Policy designed to prohibit any director,
officer or employee of the Manager from buying or selling our stock on the basis
of material nonpublic information or communicating material nonpublic
information to others.

GENERAL

We are a mortgage origination and acquisition company that originates, acquires
and invests in adjustable and variable 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 are publicly rated and include guarantees or other credit
enhancements against losses from loan defaults. While we are not a bank or
savings and loan institution, our business purpose, strategy, method of
operation and risk profile are best understood in comparison to such
institutions. We use our equity capital and borrowed funds to originate, acquire
and 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 substantially all
of our earnings through to shareholders, without paying federal or state income
tax at the corporate level. We have five qualified REIT subsidiaries, all of
which are consolidated in our financial statements and federal and state tax
returns. Two of these subsidiaries, Thornburg Mortgage Funding Corporation and
Thornburg Mortgage Acceptance Corporation, are involved in financing our
mortgage loan assets. Thornburg Mortgage Home Loans, Inc. ("TMHL"), our wholly
owned mortgage banking subsidiary, conducts our mortgage loan acquisition,
origination, processing, underwriting and securitization activities. TMHL's two
wholly owned special purpose subsidiaries, Thornburg Mortgage Funding
Corporation II and Thornburg Mortgage Acceptance Corporation II, facilitate the
financing of loans by TMHL.

22

Our mortgage assets portfolio may consist of mortgage pass-through securities
either guaranteed by an agency of the federal government, ("Ginnie Mae") or a
federally chartered corporation ("Fannie Mae" or "Freddie Mac") 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. Agency securities are MBS for which a U.S. Government agency or federally
chartered corporation, such as Freddie Mac, Fannie Mae or Ginnie Mae, guarantees
payments of principal or interest on the certificates. Agency securities are not
rated, but carry an implied AAA rating.

We also invest in hybrid ARM assets ("Hybrid ARMs"), which are typically 30-year
loans having 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. We also have a policy to fund our
+Hybrid ARM assets with fixed rate borrowings such that the duration difference
of Hybrid ARMS and the corresponding borrowings is one year or less. We use Swap
Agreements and Eurodollar Transactions to fix our borrowing cost.

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 by acquiring variable rate CMOs and CBOs, Hybrid ARMs and certain
other ARM loans that do not have a periodic cap. As of September 30, 2002,
approximately $8.3 billion of our ARM securities and ARM loans did not have
periodic caps or were Hybrid ARMs, representing approximately 83% of total ARM
assets.

Our investment policy is to invest at least 70% of total assets in High Quality
ARM assets 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 Ginnie Mae, Fannie Mae or Freddie Mac; or

(2) securities which 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"); or

(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 (as defined below) and approved
by our Board of Directors; or

(4) the portion of ARM loans that have been deposited into a trust and
have received a credit rating of AA or better from at least one Rating
Agency.

The remainder of our ARM portfolio, comprising not more than 30% of total
assets, may consist of Other Investment assets, which may include:

(1) adjustable or variable rate pass-through certificates, multi-class
pass-through certificates or CMOs backed by loans 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,
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; or

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

(4) real estate properties acquired as a result of foreclosing on our ARM
loans; or

(5) as authorized by our Board of Directors, ARM securities rated less
than Investment Grade that are created as a result of loan acquisition
and securitization efforts and that equal an amount no greater than
17.5% of shareholders' equity, measured on a historical cost basis.

23

We acquire and originate high quality mortgage loans through TMHL from three
sources: (i) bulk acquisitions, which involve acquiring pools of whole loans
which are originated using the seller's guidelines and underwriting criteria,
(ii) correspondent lending, which involves acquiring individual loans from
correspondent lenders or other loan originators who originate the individual
loans using our underwriting criteria and guidelines or criteria and guidelines
that we have approved, and (iii) direct retail loan originations, which are
loans that we originate. The loans that we acquire or originate are financed
through warehouse borrowing arrangements and securitized for our portfolio, or,
in the case of fixed rate loans, sold to third parties.

The loans acquired or originated by TMHL are first lien, residential ARM and
Hybrid ARM loans with original terms to maturity of not more than forty years
and are either fully amortizing or are interest only up to ten years, and fully
amortizing thereafter. We believe the interest only loans do not pose additional
credit risk because the effective loan-to-values average 68.7% and these loans
generally pay off prior to the expiration of the interest only term of the
loans. Interest only loans acquired or originated during the first nine months
of 2002 represented 81.7% of total loan production during that period.

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 to a margin
over a U.S. Treasury Bill index or a LIBOR 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.

We offer a loan modification program on all loans that we originate and certain
loans that we acquire. Under the terms of this program, a borrower may pay a fee
and choose to modify the interest rate of a mortgage loan to any then-available
hybrid or adjustable-rate product offered by us, at any time during the life of
the loan.

Our underwriting guidelines are intended to determine the collateral value of
the mortgaged property and to consider the borrower's credit standing and
repayment ability. Each prospective borrower completes an application that
includes information with respect to the applicant's liabilities, income and
employment history, as well as certain other personal information. A credit
report is required for each applicant from at least one credit reporting
company. The report typically contains information relating to matters such as
credit history with local and national merchants and lenders, installment debt
payments and any record of default, bankruptcy, repossession, suit or judgment.
Generally, the borrowers have credit scores, called a FICO (based upon the
credit evaluation methodology developed by Fair, Isaac and Company, a consulting
firm specializing in creating credit evaluation models) of 650 or above. On a
case-by-case basis, we may determine that, based upon compensating factors, a
prospective borrower not strictly qualifying under the applicable underwriting
guidelines warrants an underwriting exception. Compensating factors may include,
but are not limited to, low loan-to-value ratios, low debt-to-income ratios,
good credit history, stable employment, financial reserves, and time in
residence at the applicant's current address.

Our underwriting guidelines for both the correspondent and retail channels are
applied in accordance with a procedure that generally requires (1) one appraisal
report for loan amounts up to $650,000, one appraisal report and one field
review for loan amounts between $650,000 and $1,000,000, and two appraisal
reports for loan amounts greater than $1,000,000, (2) a review of such appraisal
by a third party appraisal review firm for loans over $650,000 and (3) an
internal review by us of all appraisal reports. Our underwriting guidelines
generally permit single-family mortgage loans with loan-to-value ratios at
origination of up to 95% (or, with respect to additional collateral mortgage
loans, up to 100%) for the highest credit grading category, depending on the
creditworthiness of the borrower, the type and use of the property and the
purpose of the loan application. All loans with loan-to-value ratios greater
than 80% must either have mortgage insurance or additional collateral securing
the loan.

We perform our own underwriting reviews (or contract with third parties to
perform underwriting reviews based on our guidelines) of loans that we purchase
from bulk sellers or acquire from approved correspondents. We use private label,
fee-based, third party service providers to underwrite, process and close the
loans that we originate. We also service mortgage loans that we acquire or
originate using a contract, private label subservicer. We believe the
efficiencies and expertise that our third party service providers have developed
through specialization afford us

24

an opportunity to expand our mortgage origination and loan servicing business in
a cost effective manner with minimum initial investment.

Our loan acquisition and origination strategies are designed to take advantage
of our portfolio lending capability, cost-efficient operation, competitive
advantages and available technology, enabling us to provide attractive and
innovative mortgage products, competitive mortgage rates and a high level of
customer service. By eliminating intermediaries, whenever possible, between the
borrower and the lender, we expect to acquire and originate loans for retention
in our portfolio at attractive yields, while offering our customers innovative
mortgage products at competitive rates and fees. Our expansion into residential
mortgage loan origination is intended to continue our strategy of acquiring only
high quality mortgage loans.

We 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, obtain access to a
variety of mortgage calculators and consumer help features, submit an
application on-line and begin the process of obtaining pre-approval of their
loan. Once a mortgage loan application has been submitted, one of our
representatives will assist the borrower in completing the loan process.

Since we do not invest in real estate mortgage investment conduit ("REMIC")
residuals or other CMO residuals, we do not create excess inclusion income or
unrelated business taxable income for tax-exempt investors. Therefore, our
securities are eligible for purchase by tax-exempt investors, such as pension
plans, profit sharing plans, 401(k) plans, Keogh plans and Individual Retirement
Accounts.

FINANCIAL CONDITION

At September 30, 2002, we held total assets of $10.092 billion, $9.996 billion
of which consisted of ARM assets, as compared to $5.804 billion and $5.732
billion, respectively, at December 31, 2001. Since commencing operations, we
have primarily purchased either ARM securities (backed by agencies of the U.S.
government or federally chartered corporations 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 September 30, 2002, 93.1% of our assets,
including cash and cash equivalents, were High Quality assets, far exceeding our
investment policy minimum requirement of investing at least 70% of our total
assets in High Quality ARM assets and cash and cash equivalents. Of the ARM
assets that we owned as of September 30, 2002, 91.4% were in the form of
adjustable rate pass-through certificates or ARM loans. The remainder were
floating rate classes of CMOs (5.7%), short term, fixed rate classes of CMOs
(0.9%) or investments in floating rate classes of CBOs (2.0%) backed primarily
by ARM MBS.

25

The following table presents a schedule of ARM assets owned at September 30,
2002 and December 31, 2001 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)