THORNBURG MORTGAGE ASSET CORP - 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, 1998

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 ASSET CORPORATION
(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)

119 E. MARCY STREET
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:

Title of Each Class Name of Exchange on Which Registered
- ---------------------------------------- --------------------------------------
Common Stock ($.01 par value) New York Stock Exchange
Series A 9.68% Cumulative Convertible
Preferred Stock ($.01 par value) New York Stock Exchange

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 9, 1999, the aggregate market value of the voting stock held by
non-affiliates was $199,887,825, based on the closing price of the common stock
on the New York Stock Exchange.

Number of shares of Common Stock outstanding at March 9 , 1999: 21,489,663

DOCUMENTS INCORPORATED BY REFERENCE:

Portions of the Registrant's definitive Proxy Statement dated March 29,
1999, issued in connection with the Annual Meeting of Shareholders of the
Registrant to be held on April 29, 1999, are incorporated by reference into
Parts I and III.

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1

THORNBURG MORTGAGE ASSET CORPORATION
1998 FORM 10-K ANNUAL REPORT
TABLE OF CONTENTS

PART I

Page
----

ITEM 1. BUSINESS . . . . . . . . . . . . . . . . . . . . . . 3

ITEM 2. PROPERTIES . . . . . . . . . . . . . . . . . . . . . 17

ITEM 3. LEGAL PROCEEDINGS. . . . . . . . . . . . . . . . . . 17

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. 17

PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY
AND RELATED SHAREHOLDER MATTERS. . . . . . . . . . . 18

ITEM 6. SELECTED FINANCIAL DATA. . . . . . . . . . . . . . . 19

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS. . . . 20

ITEM 7A.QUANTITATIVE AND QUALITATIVE DISCLOSURE
ABOUT MARKET RISKS . . . . . . . . . . . . . . . . . 39

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. . . . . 39

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURE. . . . . . . . . 39

PART III

ITEM 10.DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT . 39

ITEM 11.EXECUTIVE COMPENSATION . . . . . . . . . . . . . . . 39

ITEM 12.SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT . . . . . . . . . . . . . . . . . . . . . 39

ITEM 13.CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. . . 39

PART IV

ITEM 14.EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND
REPORTS ON FORM 8-K. . . . . . . . . . . . . . . . . 40

FINANCIAL STATEMENTS. . . . . . . . . . . . . . . . . . . . . F-1

SIGNATURES

EXHIBIT INDEX

2

PART I

ITEM 1. BUSINESS

GENERAL

Thornburg Mortgage Asset Corporation and subsidiaries (the "Company") is a
mortgage acquisition company that primarily invests in adjustable-rate mortgage
("ARM") assets comprised of ARM securities and ARM loans, thereby indirectly
providing capital to the single family residential housing market. In 1998, the
Company began investing in hybrid ARM assets ("Hybrid ARMs") which are included
in the Company's references to ARM securities and ARM loans. Hybrid ARMs have a
fixed rate of interest for an initial period, generally 3 to 5 years, and then
convert to an adjustable-rate for the balance of the term of the Hybrid ARM and
are funded with long-term debt obligations such that the debt obligations mature
within one year of the first interest rate reset date of the Hybrid ARMs. ARM
securities represent interests in pools of ARM loans, which often include
guarantees or other credit enhancements against losses from loan defaults.
While the Company is not a bank or savings and loan, its business purpose,
strategy, method of operation and risk profile are best understood in comparison
to such institutions. The Company leverages its equity capital using borrowed
funds, invests in ARM assets and seeks to generate income based on the
difference between the yield on its ARM assets portfolio and the cost of its
borrowings. The corporate structure of the Company differs from most lending
institutions in that the Company is organized for tax purposes as a real estate
investment trust ("REIT") and therefore generally passes through substantially
all of its 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". During 1998, in connection with the Company's
issuance of $1.1 billion of callable AAA notes, the Company formed two REIT
qualified subsidiaries. These subsidiaries are consolidated in the Company's
financial statements and federal and state tax returns.

OPERATING POLICIES AND STRATEGIES

Investment Strategies

The Company's investment strategy is to purchase ARM securities and ARM loans
originated and serviced by other mortgage lending institutions. Increasingly,
mortgage lending is being conducted by mortgage lenders who specialize in the
origination and servicing of mortgage loans and then sell these loans to other
mortgage investment institutions, such as the Company. The Company believes it
has a competitive advantage in the acquisition and investment of these mortgage
securities and mortgage loans because of the low cost of its operations relative
to traditional mortgage investors like banks and savings and loans. Like
traditional financial institutions, the Company seeks to generate income for
distribution to its shareholders primarily from the difference between the
interest income on its ARM assets and the financing costs associated with
carrying its ARM assets.

The Company purchases ARM assets from broker-dealers and financial institutions
that regularly make markets in these assets. The Company also purchases 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.

The Company's mortgage assets portfolio may consist of either agency or
privately issued securities (generally publicly registered) mortgage
pass-through securities, multiclass pass-through securities, collateralized
mortgage obligations ("CMOs"), collateralized bond obligations ("CBOs"),
generally backed by high quality mortgage backed securities, ARM loans, Hybrid
ARMs or short-term investments that either mature within one year or have an
interest rate that reprices within one year. The Company will not invest more
than 30% of its ARM assets in Hybrid ARMs and will limit its interest rate
repricing mismatch (the difference between the remaining fixed-rate period of a
Hybrid ARM and the maturity of the fixed-rate liability funding a Hybrid ARM) to
no more than one year.

3

The Company's 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 which are rated within one of the two highest rating
categories by at least one of either Standard & Poor's 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 the Company's Board
of Directors; or
(4) the portion of ARM or hybrid 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 the Company's 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 secured by first liens on single-family residential
properties, generally underwritten to "A" quality standards, and acquired for
the purpose of future securitization (see description of "A" quality in
"Portfolio of Mortgage Assets - ARM and Hybrid ARM Loans"); or
(3) a limited amount, currently $70 million as authorized by the Board of
Directors, of less than investment grade classes of ARM securities that are
created as a result of the Company's loan acquisition and securitization
efforts.

Since inception, the Company has generally invested less than 15%, currently
approximately 4%, of its total assets in Other Investment assets, excluding
loans held for securitization. Despite the generally higher yield, the Company
does not expect to significantly increase its investment in Other Investment
securities. This is primarily due to the difficulty of financing such assets at
reasonable financing terms and values through all economic cycles. Since the
Company has never had a large investment in Other Investment securities and
believes it has always been very selective and cautious regarding these
investments, this adjustment to the Company's investment strategy is not
expected to have a material impact on the Company's operating results.

The Company does not invest in REMIC residuals or other CMO residuals and,
therefore does not create excess inclusion income or unrelated business taxable
income for tax exempt investors. Therefore, the Company is a mortgage REIT
eligible for purchase by tax exempt investors, such as pension plans, profit
sharing plans, 401(k) plans, Keogh plans and Individual Retirement Accounts
("IRAs").

Acquisition of ARM and Hybrid ARM Loans

The Company acquires existing pools of ARM loans and intends to begin acquiring
individual loans directly from loan originators for future securitization.
Acquiring ARM loans for future securitization is expected to benefit the Company
by providing: (i) greater control over the types of ARM loans originated; (ii)
the ability to acquire ARM loans 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 its portfolio.

The Company acquires residential ARM and Hybrid ARM whole loans utilizing two
processes which the Company calls the Bulk Acquisition Method ("Bulk Method")
and the Flow Acquisition Method ("Flow Method"). The Bulk Method, which the
Company began utilizing in 1997, involves a number of the Company's established
relationships with mortgage originators, or mortgage aggregators, who sell the
Company pools of whole loans at market prices, with the servicing rights,
generally, remaining with the originator or seller. In cases where the Company
buys the servicing rights along with the loans, the Company contracts with a
qualified loan servicer to perform the loan servicing function for a fee. In
this Bulk Method, the loans are originated using the seller's loan products and
programs, and the credit review of the borrower and the appraisal of the
property and the quality control procedures are performed by the originators.

4

The Company only considers the purchase of loans when all of the borrowers have
had their incomes verified, their credit checked, their assets verified and
appraisals of the properties have been obtained. The Company then obtains an
independent underwriter's review, performed by a third party for the benefit of
the Company, which entails a review of the processes and closing method used by
the originators in verifying the borrower credit as well as a review of the
property valuation. In addition, the Company will, at the request of the third
party credit review providers, utilize its own personnel to re-review some of
the individual loans in order to insure the highest possible loan quality. The
Company generally selects loans for underwriting review based upon specific
criteria such as property location, loan size, effective loan-to-value ratios,
borrowers' credit scoring and other criteria the Company believes to be
important indicators of credit risk. Additionally, prior to the purchase of
loans, the Company obtains representations and warranties from each seller
stating that each loan meets the Company's underwriting standards and other
requirements. The breach of such representations and warranties in regards to a
loan can result in the seller having an obligation to repurchase the loan.

In the Flow Method, which the Company will begin utilizing in the first half of
1999, the Company acquires mortgage loans using the Company's specific loan
programs and underwriting criteria. This means that the originator/seller
originates the individual loans using the Company's established credit and
program guidelines. All program participants, (originators/sellers), are
screened by the Company as to their financial strength as well as to their own
established in-house mortgage procedures. The credit of each borrower and the
value of each property is underwritten by the originators and are subject to the
quality control procedures of the originators. This is the same process used by
originators/sellers in the Bulk Method except that all of the credit and
appraisal guidelines have been developed and designed by the Company to meet the
Company's own credit criteria and portfolio requirements. All of the loans are
then subjected to further credit review by mortgage insurance companies that
also use the Company's guidelines to insure product quality and compliance to
the Company's guidelines. The three mortgage insurance companies chosen by the
Company to perform this function use a two-step loan approval process. After
the credit review and quality control review are performed by the
originator/seller, but prior to the purchase of the loans by the Company, all of
the loans are placed through an automated underwriting system created by the
Federal National Mortgage Association ("Fannie Mae") called "Desktop
Underwriter." This is the same system used by Fannie Mae in connection with
all of their own loan purchases. Secondly, all loans that pass the Desktop
Underwriter test are then screened by the mortgage insurance company personnel
as to their compliance to the Company's guidelines. A select number of these
loans are then subjected to an additional quality control procedure performed by
a third party. Additionally, all of the loans acquired through the Flow Method
are assigned a "Risk Evaluation Score" or "Mortgage Score" by each of the
mortgage insurance companies. The risk 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. The Company believes that obtaining risk scores will help in reducing
the Company's securitization costs by insuring that the Company purchases the
highest quality mortgage loans with the lowest risk possible. As in the Bulk
Method, mortgage loans acquired through the Flow Method are acquired, generally,
with the servicing rights remaining with the originator/seller. As with the
Bulk Method, in cases where the Company buys the servicing rights along with the
loans, the Company contracts with a qualified loan servicer to perform the loan
servicing function for a fee. The Company obtains representations and
warranties from each seller or program participant stating that each loan meets
the Company's underwriting standards and other requirements. As in the Bulk
Method, the breach of such representations and warranties in regards to a loan
can result in the seller having an obligation to repurchase the loan.

In both methods the Company uses its in-house staff as well as third party due
diligence providers to verify the credit quality of the borrowers as well as the
soundness of the mortgage collateral securing the individual loans. As added
security, the Company uses the services of a third party document custodian to
insure the quality and accuracy of all individual mortgage loan documents which
are then held in safekeeping with the third-party document custodian. As a
result, all of the original individual loan documents that are signed by the
borrower, other than the original credit verification documents, are examined
and verified by the custodian.

Securitization of ARM and Hybrid ARM Loans

The Company acquires ARM and Hybrid ARM loans for its portfolio with the
intention of securitizing them in such a way as to maximize the amount of high
quality assets that can be created from an accumulation of the ARM and Hybrid
ARM loans. In order to facilitate the securitization of its loans, the Company
intends to create and retain a subordinate interest in the loans, to provide a
limited amount of credit enhancement, and then to purchase an insurance policy
from a third party financial guarantor that will "wrap" the remaining balance of
the loans to a credit rating of AA or better. Upon securitization, the Company
then plans to either own the high quality ARM certificates and the subordinate
certificates in its portfolio and finance the high quality certificates in the
repurchase agreement market, or to utilize such ARM assets to collateralize
capital markets issued debt obligations with a credit rating of AA or better
from a Rating Agency as an alternative financing source to the repurchase
agreement market.

5

Financing Strategies

The Company employs a leveraging strategy to increase its assets by borrowing
against its ARM assets and then using the proceeds to acquire additional ARM
assets. By leveraging its portfolio in this manner, the Company expects to
maintain an equity-to-assets ratio between 8% to 10%, when measured on a
historical cost basis. The Company believes that this level of capital is
sufficient to allow the Company to continue to operate in interest rate
environments in which the Company's borrowing rates might exceed its portfolio
yield. These conditions could occur when the interest rate adjustments on the
ARM assets lag the interest rate increases in the Company's variable rate
borrowings or when the interest rate of the Company's variable rate borrowings
are mismatched with the interest rate indices of the Company's ARM assets. The
Company also believes that this capital level is adequate to protect the Company
from having to sell assets during periods when the value of its ARM assets are
declining. During the fourth quarter of 1998, the Company did sell some assets
in order to increase its equity ratio from approximately 8% to over 9%, which
under the market conditions at the time was a more appropriate level. If the
ratio of the Company's equity-to-total assets, measured on a historical cost
basis, falls below 8%, the Company will take action to increase its
equity-to-assets ratio to 8% of total assets or greater, when measured on a
historical cost basis, through normal portfolio amortization, raising equity
capital, sale of assets or other steps as necessary.

The Company's ARM assets are financed primarily at short-term borrowing rates
and can be financed utilizing reverse repurchase agreements, dollar-roll
agreements, borrowings under lines of credit and other secured or unsecured
financings which the Company may establish with approved institutional lenders.
Prior to 1998, reverse repurchase agreements had been the primary source of
financing utilized by the Company to finance its ARM assets. In 1998, the
Company issued $1.1 billion of callable AAA rated notes in addition to utilizing
reverse repurchase agreements to finance its assets. Generally, upon repayment
of each reverse repurchase agreement, the ARM assets used to collateralize the
financing will immediately be pledged to secure a new reverse repurchase
agreement. The Company has established lines of credit and collateralized
financing agreements with twenty-four different financial institutions.

Reverse repurchase agreements take the form of 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 the borrower at a future date (the maturity of
the borrowing) at a higher price. The price difference is the cost of borrowing
under these agreements. In the event of the insolvency or bankruptcy of a
lender during the term of a reverse repurchase agreement, provisions of the
Federal Bankruptcy Code, if applicable, may permit the lender to consider the
agreement to resell the assets to be an executory contract that, at the lender's
option, may be either assumed or rejected by the lender. If a bankrupt lender
rejects its obligation to resell pledged assets to the Company, the Company's
claim against the lender for the damages resulting therefrom 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 actually suffered by the Company. To
mitigate this risk the Company enters into collateralized borrowings with only
financially sound institutions approved by the Board of Directors, including a
majority of unaffiliated directors, and monitors the financial condition of such
institutions on a regular, periodic basis.

The Company, commencing in 1998, also utilizes capital market transactions by
issuing debt collateralized by specific pools of ARM assets that are placed in a
trust. The financing of ARM assets in this way eliminates the risk of margin
calls on the financing of those ARM assets and limits the Company's exposure to
credit risk on the ARM and Hybrid ARM loans collateralizing such debt. The
Company receives a credit rating on the debt based on the quality of the ARM
assets, amount of any credit enhancement obtained and subordination levels of
the debt proscribed by the rating agency(ies), all of which affects the interest
rate at which the debt can be issued. The principal and interest payments on
the debt are paid by the trust out of the cash flows received on the collateral.
By utilizing such a structure, the Company can issue either floating rate debt
indexed to various indices that more closely matches the characteristics of the
collateralized ARM assets, depending upon market constraints and conditions, or
fixed rate debt that corresponds to the characteristics of collateralized Hybrid
ARM loans.

6

The Company also enters into financing facilities for whole loans. The Company
uses these credit lines to finance its acquisition of whole loans while it is
accumulating loans for securitization or until more permanent financing is
arranged in a capital markets collateralized debt transaction. In 1998, the
Company utilized two whole loan financing facilities that provided the Company
with uncommitted lines of credit based on the market value of its whole loans.
Uncommitted lines of credit are generally less expensive than a committed line
of credit, but during periods of market turmoil, uncommitted lines of credit can
be terminated by the counterparty with little notice to the Company and at a
time when the Company would have difficulty in replacing the line of credit.
Therefore, beginning in 1999, the Company has decided to negotiate and pay a fee
for committed facilities as well as continue to utilize uncommitted facilities.
During January 1999, the Company entered into one committed facility in the
amount of $150,000,000, which the Company can increase to $300,000,000 for an
additional fee, and is negotiating a number of other committed and uncommitted
facilities.

The Company mitigates its interest-rate risk from borrowings by selecting
maturities that approximately match the interest-rate adjustment periods on its
ARM assets. Accordingly, borrowings bear variable or short-term fixed (one year
or less) interest rates. Generally, the borrowing agreements require the
Company to deposit additional collateral in the event the market value of
existing collateral declines, which, in dramatically rising interest rate
markets, could require the Company to sell assets to reduce the borrowings.

The Company's 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 the
Company's net assets, on a consolidated basis, unless approved by a majority of
the unaffiliated directors. This limitation generally applies only to unsecured
borrowings of the Company. For this purpose, the term "net assets" means the
total assets (less intangibles) of the Company 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 the Company's ability to finance its total assets with collateralized
borrowings.

Hedging Strategies

The Company makes use of hedging transactions to mitigate the impact of certain
adverse changes in interest rates on its net interest income. In general, ARM
assets have a maximum lifetime interest rate cap, or ceiling, meaning that each
ARM asset contains a contractual maximum rate. The borrowings incurred by the
Company to finance its ARM assets portfolio are not subject to equivalent
interest rate caps. Accordingly, the Company purchases interest rate cap
agreements ("Cap Agreements") to prevent the Company's borrowing costs from
exceeding the lifetime maximum interest rate on its ARM assets. These Cap
Agreements have the effect of offsetting a portion of the Company's borrowing
costs if prevailing interest rates exceed the rate specified in the Cap
Agreement. A Cap Agreement is a contractual agreement for which the Company
pays 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, 1998, the Company will receive cash payments if the
one-month, three-month or six-month LIBOR index increases above certain
specified levels, which range from 7.50% to 13.00% and average approximately
10.10%. The fair value of these Cap Agreements also tends to increase when
general market interest rates increase and decrease when market interest rates
decrease, helping to partially offset changes in the fair value of the Company's
ARM assets.

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 incurred by the Company do not have
similar periodic caps. The Company generally does not hedge against the risk of
its 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. The
Company attempts to mitigate the effect of periodic caps in several ways.
First, the yield on the Company's ARM assets can change by more that the 1% or
2% per periodic interest rate adjustment limitation depending upon how
prepayment activity changes as interest rates change. Secondly, during 1998,
the Company began to acquired variable rate CMOs and CBOs ("Floaters"), Hybrid
ARMs and certain other ARM loans that do not have a periodic cap. As of
December 31, 1998, approximately $622.9 million of the Company's ARM securities
and $909.2 million of the Company's ARM loans did not have periodic caps or were
Hybrid ARMs, representing approximately 36% of total ARM assets.

7

The Hybrid ARMs have an initial fixed rate period, generally 3 to 5 years.
Since the Company's borrowings are generally short-term, the Company enters into
interest rate swap agreements that hedge a portion of the fixed rate period, so
that the unhedged fixed rate period is no more than one year. In accordance
with the terms of these swap agreements, the Company pays a fixed rate of
interest during the term of the agreements, and receives a payment that varies
monthly with the one month LIBOR Index. Due to the longer term nature of these
agreements and because the hedged Hybrid ARMs are amortizing based on homeowner
scheduled payments and unscheduled prepayments, the Company generally enters
into both a swap that amortizes at an agreed upon single prepayment rate and an
additional swap that amortizes at a prepayment rate which the Company has the
option to change monthly within a range of rates.

The Company also enters into interest rate swap agreements to manage the average
interest rate reset period on its borrowings. In accordance with the terms of
the swap agreements, the Company pays a fixed rate of interest during the term
of the agreements and receives a payment that varies monthly with the one month
LIBOR Index. These agreements have the effect of fixing the Company's borrowing
costs on a similar amount of swaps owned by the Company and, as a result, the
Company reduces the interest rate variability of its borrowings. The Company
may also use interest rate swap agreements from time to time to change from one
interest rate index to another interest rate index and thus decrease further the
basis risk between the Company's interest yielding assets and the financing of
such assets.

The ARM assets held by the Company were generally purchased at prices greater
than par. The Company is amortizing 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 the Company's ARM assets differs from expectations,
the Company's 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 the Company's ARM assets, the Company's net
income and, therefore, the amount available for dividends could be adversely
affected. To mitigate the adverse effect of an increase in prepayments on the
Company's ARM assets, the Company has purchased ARM assets at prices at or below
par, however the Company's portfolio of ARM assets is currently held at a net
premium. The Company 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, the
Company has not purchased any "principal only" mortgage derivative assets.

The Company may enter into other hedging-type transactions designed to protect
its borrowings costs or portfolio yields from interest rate changes. Such
transactions may include the purchase or sale of interest rate futures contracts
or options on interest rate futures contracts. The Company may also purchase
"interest only" mortgage derivative assets or other derivative products for
purposes of mitigating risk from interest rate changes. The Company has not, to
date, entered into these types of transactions, but may do so in the future.
The Company will not invest in any futures transactions unless the Company and
Thornburg Mortgage Advisory Corporation (the "Manager") are exempt from the
registration requirements of the Commodities Exchange Act or otherwise comply
with the provisions of that Act.

Hedging transactions currently utilized by the Company generally are designed to
protect the Company's net interest income during periods of rising market
interest rates. The Company does not intend to hedge for speculative purposes.
Further, no hedging strategy can completely insulate the Company from risk, and
certain of the federal income tax requirements that the Company must satisfy to
qualify as a REIT limit the Company's ability to hedge, particularly with
respect to hedging against periodic cap risk. The Company carefully monitors
and may have to limit its hedging strategies to ensure that it does 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

The Board of Directors has established the Company's operating policies and any
revisions in the operating policies and strategies require the approval of the
Board of Directors, including a majority of the unaffiliated directors. Except
as otherwise restricted, the Board of Directors has the power to modify or alter
the operating policies without the consent of shareholders. Developments in the
market which affect the operating policies and strategies mentioned herein or
which change the Company's assessment of the market may cause the Board of
Directors (including a majority of the unaffiliated directors) to revise the
Company's operating policies and financing strategies.

In the event the rating of an ARM security held by the Company is reduced by the
Rating Agencies to below Investment Grade after acquisition by the Company, the
asset may be retained in the Company's investment portfolio if the Manager
recommends that it be retained and the recommendation is approved by the Board
of Directors (including a majority of the unaffiliated directors).

8

The Company has elected to qualify as a REIT for tax purposes. The Company has
adopted certain compliance guidelines which include restrictions on the
acquisition, holding and sale of assets. Prior to the acquisition of any asset,
the Company determines whether such asset will constitute a "Qualified REIT
Asset" as defined by the Internal Revenue Code of 1986, as amended (the "Code").
Substantially all the assets that the Company has acquired and will acquire for
investment are expected to be Qualified REIT Assets. This policy limits the
investment strategies that the Company may employ.

The Company closely monitors its purchases of ARM assets and the income from
such assets, including from its hedging strategies, so as to ensure at all times
that it maintains its qualification as a REIT. The Company developed certain
accounting systems and testing procedures with the help of qualified accountants
and tax experts to facilitate its ongoing compliance with the REIT provisions of
the Code. See "Federal Income Tax Considerations - Requirements for
Qualification as a REIT". No changes in the Company's investment policies and
operating policies and strategies, including credit criteria for mortgage asset
investments, may be made without the approval of the Company's Board of
Directors, including a majority of the unaffiliated directors.

The Company at all times intends to conduct its business so as not to become
regulated as an investment company under the Investment Company Act of 1940.
The Investment Company Act exempts entities that are "primarily engaged in the
business of purchasing or otherwise acquiring mortgages and other liens on and
interests in real estate" ("Qualifying Interests"). Under current
interpretation of the staff of the SEC, in order to qualify for this exemption,
the Company must maintain at least 55% of its assets directly in Qualifying
Interests. In addition, unless certain mortgage assets represent all the
certificates issued with respect to an underlying pool of mortgages, such
mortgage assets may be treated as assets separate from the underlying mortgage
loans and, thus, may not be considered Qualifying Interests for purposes of the
55% requirement. The Company closely monitors its compliance with this
requirement and intends to maintain its exempt status. Up to the present, the
Company has been able to maintain its exemption through the purchase of whole
pool 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".

The Company does 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. Any changes in this policy would be
subject to approval by the Board of Directors, including a majority of the
unaffiliated directors.

PORTFOLIO OF MORTGAGE ASSETS

As of December 31, 1998, ARM assets comprised approximately 98% of the Company's
total assets. The Company has invested in the following types of mortgage
assets in accordance with the operating policies established by the Board of
Directors and described in "Business - Operating Policies and Strategies -
Operating Restrictions".

PASS-THROUGH CERTIFICATES

The Company's investments in mortgage assets are concentrated in High Quality
ARM pass-through certificates which account for approximately 90% of ARM assets
held. These High Quality ARM pass-through certificates consist of Agency
Certificates and privately issued ARM pass-through certificates that meet the
High Quality credit criteria. These High Quality ARM pass-through certificates
acquired by the Company represent interests in ARM loans which are secured
primarily by first liens on single-family (one-to-four units) residential
properties, although the Company may also acquire ARM pass-through certificates
secured by liens on other types of real estate-related properties. The Company
also includes 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 its AAA
notes payable in the amount equivalent to the AAA portion of the debt issued by
the trust. The ARM pass-through certificates, including the ARM and Hybrid ARM
loans collateralizing AAA notes payable, acquired by the Company are generally
subject to periodic interest rate adjustments, as well as periodic and lifetime
interest rate caps which limit the amount an ARM security's interest rate can
change during any given period.

9

The following is a discussion of each type of pass-through certificate held by
the Company as of December 31, 1998:

FHLMC ARM Programs

FHLMC is a shareholder-owned government sponsored enterprise created pursuant to
an Act of Congress on July 24, 1970. The principal activity of FHLMC 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. During
1998, FHLMC issued $7.2 billion of FHLMC ARM certificates and as of December 31,
1998, there was $37.5 billion of all types of FHLMC ARM certificates
outstanding, of which FHLMC held $9.8 billion in its own portfolio.

Each FHLMC 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 FHLMC. 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 rate paid on FHLMC 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.

FHLMC guarantees to each holder of its ARM Certificates the timely payment of
interest at the applicable pass-through rate and 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 FHLMC under its
guarantees are solely those of FHLMC and are not backed by the full faith and
credit of the U.S. Government. If FHLMC were unable to satisfy such
obligations, distributions to holders of FHLMC ARM Certificates would consist
solely of payments and other recoveries on the underlying mortgage loans and,
accordingly, monthly distributions to holders of FHLMC ARM Certificates would be
affected by delinquent payments and defaults on such mortgage loans.

FNMA ARM Programs

FNMA is a federally chartered and privately owned corporation organized and
existing under the Federal National Mortgage Association Charter Act. FNMA
provides funds to the mortgage market primarily by purchasing home mortgage
loans from mortgage loan originators, thereby replenishing their funds for
additional lending. FNMA 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.
During 1998, FNMA issued $14.0 billion of FNMA ARM certificates and as of
December 31, 1998, there was $59.0 billion of all types of FNMA ARM certificates
outstanding, of which FNMA held $11.9 billion in its own portfolio.

Each FNMA 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 FNMA. 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 terms to maturities of the mortgage loans generally do not exceed 40
years. FNMA 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 FNMA's guarantee fee.

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

10

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 non-conforming conventional
adjustable-rate mortgage loans and are generally structured with one or more
types of credit enhancement, including pool insurance, guarantees, or
subordination. Accordingly, the privately issued ARM pass-through certificates
typically are not guaranteed by an entity having the credit status of FHLMC or
FNMA.

Privately issued ARM pass-through certificates credit enhanced by mortgage pool
insurance provide the Company with an alternative source of ARM assets (other
than Agency ARM assets) that meet the Qualifying Interests test for purposes
maintaining the Company's exemption under the Investment Company Act of 1940.
Since the inception of the Company in 1993, most of the providers of mortgage
pool insurance have stopped providing such insurance. Therefore, the Company
has increased its investment in Agency ARM securities and in whole loans as its
primary sources of Qualifying Interests in real estate.

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

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. The CBOs acquired by the
Company, like CMOs, are debt obligations, but, in the case of CBOs, 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. The Company only acquires CBO's that have portfolios
that consist primarily of either real estate qualifying assets or high quality
mortgage backed securities. Multiclass 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 multiclass 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 multiclass
pass-throughs. In a CBO transaction, principal and interest payments are used
to pay current period interest and any excess is reinvested into the portfolio.
CBOs typically don't amortize monthly, rather they mature on a specific maturity
date. Scheduled payments of principal and interest on the mortgage-related
assets and other collateral securing a series of CMOs, CBOs or multiclass
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.

Multiclass pass-through securities backed by ARM assets or ARM loans owned by
the Company are typically structured into classes designated as senior classes,
mezzanine classes and subordinated classes. The Company also owns variable rate
classes of CMOs and CBOs that are backed by both fixed- and adjustable-rate
mortgages.

The senior classes in a multiclass 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
multiclass pass-through security.

The mezzanine classes of a multiclass 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, but not all,
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 the Company has acquired are rated High
Quality.

Subordinated classes are junior in the right to receive payment from the
underlying mortgages to other classes of a multiclass 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.

11

The Subordinated classes which the Company has 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 the Company's process
of securitizing whole loans. The Subordinated classes acquired by the Company
in the open market are limited in amount and bear yields which the Company
believes are commensurate with the increased risks involved. In general, the
Company acquires subordinated classes when they are seasoned and when the more
senior classes of the multi-class security have been paid down to levels that
mitigate the risk of non-payment on the subordinate classes.

The market for Subordinated classes is not extensive and at times may be
illiquid. In addition, the Company's ability to sell Subordinated classes is
limited by the REIT Provisions of the Code. The Company has not purchased any
Subordinated classes that are not Qualified REIT Assets. The Subordinated
classes acquired by the Company, which are not High Quality, together with the
Company's other investments in Other Investment assets, may not, in the
aggregate, comprise more than 30% of the Company's total assets, in accordance
with the Company's investment policy.

The variable rate classes of CMOs and CBOs, or Floaters, owned by the Company
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

The ARM and Hybrid ARM loans the Company has acquired are all first mortgages on
single-family residential properties. Some have additional collateral in the
form of pledged financial assets that provides the Company with additional
credit protection in exchange for a simpler application and approval process.
The Company acquires loans are underwritten to "A" quality standards. The
Company considers loans to be "A" quality when they are underwritten in such a
way as to assure that the mortgages are protected by adequate borrower income to
make the required loan payment, adequate verifiable equity in the underlying
property, and by the borrower's willingness and ability to repay the mortgage as
demonstrated by a good credit history. As a result, the loans are generally
fully documented loans to borrowers with good credit histories, adequate income
to support the monthly mortgage payment, adequate assets to close the loan, with
80% or lower effective loan-to-value ratios based on independently appraised
property values or are seasoned loans with over five years or more of good
payment history.

When acquiring ARM and Hybrid ARM loans, either originated specifically for the
Company or when the Company acquires pools of loans in bulk, the Company focuses
its attention on key aspects of a borrower's profile and the characteristics of
a mortgage loan product that the Company believes are most important in insuring
excellent loan performance and minimal credit exposure. The Company's loan
programs focus on larger down payments, excellent borrower credit history (as
measured by a credit report and a credit score) and a conservative appraisal
process. If an ARM or Hybrid ARM loan acquired has a loan to property value
that is above 80%, then the borrower is required to pay for private mortgage
insurance providing additional protection to the Company against credit risk.
The loans acquired have original maturities of forty years or less. The ARM
and Hybrid ARM loans are either fully amortizing or are interest only for up to
ten years and fully amortizing thereafter. All ARM loans acquired bear an
interest rate that is tied to an interest rate index and some 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 indices the ARM loans are tied to are generally a U.S. Treasury
Bill index, LIBOR, Certificate of Deposit, a Cost of Funds index or Prime. The
Hybrid ARM loans have an initial fixed rate period, generally 3 to 5 years, and
then they convert to an ARM loan with the features of an ARM loan described
above.

12

RISK FACTORS

FORWARD-LOOKING STATEMENTS

In accordance with the Private Securities Litigation Reform Act of 1995
(the "1995 Act"), the Company 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. Accordingly,
the following information contains or may contain forward-looking statements:
(1) information included in this Annual Report on Form 10-K, including, without
limitation, statements made regarding investments in ARM securities and ARM
loans, and Hybrid ARM loans, hedging, leverage, interest rates and statements in
Item 7, Management's Discussion and Analysis of Financial Condition and Results
of Operations, (2) information included in future filings by the Company with
the Securities and Exchange Commission including, without limitation, statements
with respect to growth, projected revenues, earnings, returns and yields on its
portfolio of mortgage assets, the impact of interest rates, costs, and business
strategies and plans, and (3) information contained in the Company's Annual
Report or other written material, releases and oral statements issued by or on
behalf of, the Company, including, without limitation, statements with respect
to growth, projected revenues, net income, returns and yields on its portfolio
of mortgage assets, the impact of interest rates, costs and business strategies
and plans.

The following is a summary of the factors the Company believes important
and that could cause actual results to differ from the Company's expectations.
The Company is publishing these factors pursuant to the 1995 Act. Such factors
should not be construed as exhaustive or as an admission regarding the adequacy
of disclosure made by the Company prior to the effective date of the 1995 Act.
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. No assurance is or
can be given that any important factor set forth below will be realized in a
manner so as to allow the Company to achieve the desired or projected results.
The words "believe," "except," "anticipate," "intend," "aim," "will," and
similar words identify forward-looking statements. The Company cautions readers
that the following important factors, among others, could affect the Company's
actual results and could cause the Company's actual consolidated results to
differ materially from those expressed in any forward-looking statements made by
or on behalf of the Company.

- - A Dramatic Increase in Short-term Interest Rates

- - The Effectiveness of Using Various Interest Rate Derivative Instruments
for Hedging ARM Assets or Borrowing Costs

- - The Ability to Acquire Attractively Priced and Underwritten ARM and Hybrid
ARM Loans and Securities

- - Interest Rate Repricing Mismatch Between Asset Yields and Borrowing Rates

- - A Decline in the Market Value of ARM Securities, Which Would Result in
Margin Calls

- - Unanticipated Levels of Prepayment Rates

- - A Flattening or Inversion of the Yield Curve Between Short and Long-Term
Interest Rates

- - The Use of Substantial Borrowed Funds to Enhance Returns

- - Risk of Credit Loss Associated with Acquiring, Accumulating and
Securitizing ARM Loans

- - Interest Rate Risks Associated with any Future Unhedged Portion of the
Fixed Term of Hybrid ARMs

- - The Loss of Key Personnel

- - Fundamental Changes in Investment Policies and Strategies

- - Fluctuations or Variability of Dividend Distributions

- - Capital Stock Price Volatility

13

COMPETITION

In acquiring ARM assets, the Company competes with other mortgage REITs,
investment banking firms, savings and loan associations, banks, mortgage
bankers, insurance companies, mutual funds, other lenders, FNMA, FHLMC and other
entities purchasing ARM assets, many of which have greater financial resources
than the Company. The existence of these competitive entities, as well as the
possibility of additional entities forming in the future, 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, 1998, the Company had no employees. Thornburg Mortgage
Advisory Corporation (the "Manager") carries out the day to day operations of
the Company, subject to the supervision of the Board of Directors and under the
terms of a management agreement discussed below.

THE MANAGEMENT AGREEMENT

On June 17, 1994, the Company renewed its management agreement with Thornburg
Mortgage Advisory Corporation (the "Management Agreement"), the Manager, for a
term of five years, with an annual review required each year. On December 15,
1995, the Agreement was amended to provide that in the event a person or entity
obtains more than 20% of the Company's common stock, if the Company is combined
with another entity, or if the Company terminates the Agreement other than for
cause, the Company is obligated to acquire substantially all of the assets of
the Manager through an exchange of shares with a value based on a formula tied
to the Manager's net profits. The Company has 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 the Company's Board of
Directors and has only such functions and authority as the Company may delegate
to it. The Manager is responsible for the day-to-day operations of the Company
and performs such services and activities relating to the assets and operations
of the Company as may be appropriate.

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 Agreement), payable monthly in arrears. The Manager
is also entitled to receive, as incentive compensation for each fiscal quarter,
an amount equal to 20% of the Net Income of the Company, 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. For further information
regarding the base management fee, incentive compensation and applicable
definitions, see the Company's Proxy Statement dated March 29, 1999 under the
caption "Certain Relationships and Related Transactions".

Subject to the limitations set forth below, the Company pays all operating
expenses except those specifically required to be paid by the Manager under the
Management Agreement. The operating expenses required to be paid by the Manager
include the compensation of the Company's officers and the cost of office space,
equipment and other personnel required for the Company's day-to-day operations.
The expenses that will be paid by the Company will include issuance and
transaction costs incident to the acquisition, disposition and financing of
investments, regular legal and auditing fees and expenses, the fees and expenses
of the Company's directors, the costs of printing and mailing proxies and
reports to shareholders, the fees and expenses of the Company's custodian and
transfer agent, if any, and reimbursement of any obligation of the Manager for
any New Mexico Gross Receipts Tax liability. The expenses required to be paid
by the Company which are attributable to the operations of the Company shall be
limited to an amount per year equal to the greater of 2% of the Average Net
Invested Assets of the Company or 25% of the Company's Net Income for that year.
The determination of Net Income for purposes of calculating the expense
limitation will be the same as for calculating the Manager's incentive
compensation except that it will include any incentive compensation payable for
such period. Expenses in excess of such amount will be paid by the Manager,
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, such expenses may be recovered by the Manager in
succeeding years to the extent that expenses in succeeding quarters are below
the limitation of expenses. The Company, rather than the Manager, will also be
required to pay expenses associated with litigation and other extraordinary or
non-recurring expenses. Expense reimbursement will be made monthly, subject to
adjustment at the end of each year.

14

The transaction costs incident to the acquisition and disposition of
investments, the incentive compensation and the New Mexico Gross Receipts Tax
liability will not be subject to the 2% limitation on operating expenses.
Expenses excluded from the expense limitation are those incurred in connection
with the servicing of mortgage loans, the raising of capital, the acquisition of
assets, interest expenses, taxes and license fees, non-cash costs and the
incentive management fee.

FEDERAL INCOME TAX CONSIDERATIONS

GENERAL

The Company has elected to be treated as a REIT for federal income tax purposes.
In brief, if certain detailed conditions imposed by the REIT provisions of the
Code are met, electing entities that invest primarily in real estate investments
and mortgage loans, and that otherwise would be taxed as corporations are, with
certain limited exceptions, not taxed at the corporate level on their taxable
income that is currently distributed to their shareholders. This treatment
eliminates most of the "double taxation" (at the corporate level and then again
at the shareholder level when the income is distributed) that typically results
from the use of corporate investment vehicles.

In the event that the Company does not qualify as a REIT in any year, it would
be subject to federal income tax as a domestic corporation and the amount of the
Company's after-tax cash available for distribution to its shareholders would be
reduced. The Company believes it has satisfied the requirements for
qualification as a REIT since commencement of its operations in June 1993. The
Company intends 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, the Company must meet
certain tests which are described briefly below.

Ownership of Common Stock

For all taxable years after the first taxable year for which a REIT election is
made, the Company's shares of capital stock must be held by a minimum of 100
persons 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 the capital stock of the Company may
be owned directly or indirectly by five or fewer individuals. The Company is
required to maintain records regarding the actual and constructive ownership of
its shares, and other information, and to demand statements from persons owning
above a specified level of the REIT's shares (as long as the Company has over
200 or more shareholders, only persons holding 1% or more of the Company's
outstanding shares of capital stock) regarding their ownership of shares. The
Company must keep a list of those shareholders who fail to reply to such a
demand.

The Company is required to use the calendar year as its taxable year for income
purposes.

Nature of Assets

On the last day of each calendar quarter at least 75% of the value of the
Company's assets must consist of Qualified REIT Assets, government assets, cash
and cash items. The Company expects that substantially all of its assets will
continue to be Qualified REIT Assets. On the last day of each calendar quarter,
of the investments in assets not included in the foregoing 75% assets test, the
value of securities issued by any one issuer may not exceed 5% in value of the
Company's total assets and the Company may not own more than 10% of any one
issuer's outstanding voting securities. Pursuant to its compliance guidelines,
the Company intends to monitor closely the purchase and holding of its assets in
order to comply with the above assets tests.

15

Sources of Income

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

1. THE 75% TEST. At least 75% of the Company's 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 the Company has 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 its gross income
from the sources listed above, at least an additional 20% of the Company's 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. The Company intends to limit substantially
all of the assets that it acquires (other than stock in certain affiliate
corporations as discussed below) to Qualified REIT Assets. The policy of the
Company to maintain REIT status may limit the type of assets, including hedging
contracts and other assets, that the Company otherwise might acquire.

Distributions

The Company must distribute to its shareholders on a pro rata basis each year an
amount equal to at least (i) 95% of its taxable income before deduction of
dividends paid and excluding net capital gain, plus (ii) 95% 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". The Company intends to make
distributions to its shareholders in sufficient amounts to meet this 95%
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. The Company believes that its DRP complies with this
ruling.

TAXATION OF THE COMPANY'S SHAREHOLDERS

For any taxable year in which the Company is treated as a REIT for federal
income purposes, amounts distributed by the Company to its 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. Distributions of the
Company will not be eligible for the dividends received deduction for
corporations. Shareholders may not deduct any net operating losses or capital
losses of the Company.

If the Company makes distributions to its shareholders in excess of its 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 the Company's shares.
The Company will withhold 30% of dividend distributions to shareholders that the
Company knows to be foreign persons unless the shareholder provides the Company
with a properly completed IRS form for claiming the reduced withholding rate
under an applicable income tax treaty.

The Clinton Administration has introduced a proposal in the fiscal 2000 federal
budget that would limit the aggregate value of businesses undertaken by a REIT
through taxable subsidiaries to 5% or less of the REIT's total assets. The
Company may from time to time hold, through one or more taxable subsidiaries,
assets that, if held directly by the Company, could otherwise generate income
that would have an adverse effect on the Company's qualification as a REIT or on
certain classes of the Company's shareholders. The Company does not reasonably
expect that the value of any such taxable subsidiaries, in the aggregate, ever
to exceed 5% of the Company's assets and therefore the Company does not
anticipate that the proposal, if enacted, would have a material effect on the
Company's operations.

The provisions of the Code are highly technical and complex. This summary is
not intended to be a detailed discussion of all applicable provisions of the
Code, the rules and regulations promulgated thereunder, or the administrative
and judicial interpretations thereof. The Company has not obtained a ruling
from the Internal Revenue Service with respect to tax considerations relevant to
its organization or operation, or to an acquisition of its common stock. This
summary is not intended to be a substitute for prudent tax planning, and each
shareholder of the Company 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 stock of the Company and any potential
changes in applicable law.

16

ITEM 2. PROPERTIES

The Company's principal executive offices are located in Santa Fe, New
Mexico and are provided by the Manager in accordance with the Management
Agreement. The Company's two subsidiaries have their principal offices in
Irvine, California.

ITEM 3. LEGAL PROCEEDINGS

At December 31, 1998, there were no pending legal proceedings to which the
Company was a party or of which any of its property was subject.

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

No matters were submitted to a vote of the Company's shareholders during
the fourth quarter of 1998.

17

PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER
MATTERS

The Company's common stock is traded on the New York Stock Exchange under the
trading symbol "TMA". As of January 31, 1999, the Company had 21,989,679 shares
of common stock issued and 21,489,663 shares of common stock outstanding which
were held by 1,161 holders of record and approximately 17,355 beneficial owners.

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

Cash
Stock Prices Dividends
---------------------------- Declared
1998 High Low Close Per Share
- ---- --------- --------- ------ --------

Fourth Quarter ended December 31, 1998 9 1/2 5 5/8 7 5/8 $ 0.23
Third Quarter ended September 30, 1998 13 5/8 7 3/16 9 - (1)
Second Quarter ended June 30, 1998 . . 16 1/8 10 1/2 11 7/8 $ 0.30
First Quarter ended March 31, 1998 . . 18 1/2 14 3/4 15 7/8 $ 0.375

1997
- ----

Fourth Quarter ended December 31, 1997 22 1/4 15 7/8 16 1/2 $ 0.50
Third Quarter ended September 30, 1997 24 9/16 20 21 $ 0.50
Second Quarter ended June 30, 1997 . . 22 1/8 17 3/4 21 1/2 $ 0.49
First Quarter ended March 31, 1997 . . 22 7/8 18 3/4 19 $ 0.48

1996
- ----

Fourth Quarter ended December 31, 1996 21 1/2 16 1/8 21 3/8 $ 0.45
Third Quarter ended September 30, 1996 17 5/8 14 7/8 16 1/4 $ 0.40
Second Quarter ended June 30, 1996 . . 17 14 1/8 16 1/4 $ 0.40
First Quarter ended March 31, 1996 . . 16 5/8 14 1/8 14 3/8 $ 0.40

- ----------------
(1) On August 17, 1998, the Company's Board of Directors announced that
dividends on common stock, in the future, would be declared after each
quarter-end rather than during the applicable quarter. The fourth quarter of
1998 dividend was declared in January 1999 and paid in February 1999.

The Company intends to pay quarterly dividends and to make such distributions to
its shareholders in such amounts that all or substantially all of its taxable
income each year (subject to certain adjustments) is distributed, so as to
qualify for the tax benefits accorded to a REIT under the Code. All
distributions will be made by the Company at the discretion of the Board of
Directors and will depend on the earnings and financial condition of the
Company, maintenance of REIT status and such other factors as the Board of
Directors may deem relevant from time to time.

DIVIDEND REINVESTMENT PLAN

The Company has a Dividend Reinvestment and Stock Purchase Plan (the "DRP") that
allows both common and preferred shareholders to have their dividends reinvested
in additional shares of common stock and to purchase additional shares. The
common stock to be acquired for distribution under the DRP may be purchased at
the Company's discretion from the Company at a discount from the then prevailing
market price or in the open market. Shareholders and non-shareholders also can
make additional purchases of stock monthly, subject to a minimum of $100 ($500
for non-shareholders) and a maximum of $5,000 for each optional cash purchase.
Continental Stock Transfer & Trust Company (the "Agent"), the Company's transfer
agent, is the Trustee and administrator of the DRP. Additional information
about the details of the DRP and a prospectus are available from the Agent or
the Company. Shareholders who own stock that is registered in their own name
and want to participate must deliver a completed enrollment form to the Agent.
Forms are available from the Agent or the Company. Shareholders who own stock
that is registered in a name other than their own (e.g., broker or bank nominee)
and want to participate 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.

18

ITEM 6. SELECTED FINANCIAL DATA

The following selected financial data are derived from audited financial
statements of the Company for the years ended December 31, 1998, 1997, 1996,
1995 and 1994. The selected financial data should be read in conjunction with
the more detailed information contained in the Financial Statements and Notes
thereto 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
1998 1997 1996 1995 1994
-------- -------- -------- -------- --------

Net interest income . . . . . . . . . $31,040 $49,064 $30,345 $13,496 $13,055
Net income. . . . . . . . . . . . . . $22,695 $41,402 $25,737 $10,452 $11,946
Basic earnings per share. . . . . . . $ 0.75 $ 1.95 $ 1.73 $ 0.88 $ 1.02
Diluted earnings per share. . . . . . $ 0.75 $ 1.94 $ 1.73 $ 0.88 $ 1.02
Average common shares . . . . . . . . 21,488 18,048 14,874 11,927 11,759
Distributable income per common share $ 0.84 $ 1.98 $ 1.76 $ 0.92 $ 1.02
Dividends declared per common share . $ 0.905 $ 1.97 $ 1.65 $ 0.93 $ 1.00
Noninterest expense to average assets 0.13% 0.21% 0.21% 0.13% 0.11%

BALANCE SHEET HIGHLIGHTS
As of December 31
---------------------------------------------------------------
1998 1997 1996 1995 1994
----------- ----------- ----------- ----------- -----------

Adjustable-rate mortgage assets . . . . . . . . . . $4,268,417 $4,638,694 $2,727,875 $1,995,287 $1,727,469
Total assets. . . . . . . . . . . . . . . . . . . . $4,344,633 $4,691,115 $2,755,358 $2,017,985 $1,751,832
Shareholders' equity (1) . . . . . . . . . . . . . $ 395,484 $ 380,658 $ 238,005 $ 182,312 $ 180,035
Historical book value per share (2) . . . . . . . . $ 15.34 $ 15.53 $ 14.67 $ 14.96 $ 15.29
Market value adjusted book value per share (3). . . $ 11.45 $ 14.42 $ 13.70 $ 13.16 $ 10.19
Number of common shares outstanding . . . . . . . . 21,490 20,280 16,219 12,191 11,773
Yield on ARM assets . . . . . . . . . . . . . . . . 5.86% 6.38% 6.64% 6.73% 5.66%
Yield on net int.-earning assets (Portfolio Margin) 0.61% 0.96% 1.34% 1.11% 0.17%
Return on average common equity . . . . . . . . . . 4.80% 12.72% 11.68% 5.81% 6.94%

- ---------------------------------------------------
(1) Shareholders' equity before unrealized market value adjustments.
(2) Shareholders' equity before unrealized market value adjustments, excluding preferred stock, divided by
common shares outstanding.
(3) Shareholders' equity, excluding preferred stock, divided by common shares outstanding.

19

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

OVERVIEW OF FOURTH QUARTER 1998 EVENTS IN THE MORTGAGE MARKET

Like most other mortgage finance companies, the Company was affected by turmoil
in the global and domestic financial markets during the fourth quarter of 1998.
Due to turbulent market conditions, the Company saw its portfolio asset values
decline, its margin requirements for financing certain of its ARM assets
increase, especially with respect to its non-agency portfolio, and the market
value of its hedging instruments decline, which required the Company to post
additional collateral and caused the Company difficulty in financing its less
than AA rated assets at acceptable valuations. Additionally, due to the high
level of prepayments on its agency securities, which the Company must fund out
of its excess liquidity prior to receipt of payments from FNMA and FHLMC, and
the heightened sense of risk aversion on the part of the Company's lenders, the
Company's level of available excess cash and liquid securities diminished from
levels maintained in prior periods. All of these factors combined to reduce the
level of liquidity available to the Company during the fourth quarter of 1998.
The Company undertook several measures to increase its liquidity during these
difficult market conditions. First, the Company requested that its lenders not
make margin calls on its loans backed by agency securities until the applicable
payments had been received by the Company. Several lenders agreed to this
request. Second, the Company undertook the sale of certain assets in order to
reduce its asset portfolio. Accordingly, during the fourth quarter, the Company
sold $421.2 million of ARM assets and recorded a loss on sale of $4.1 million.
Of this loss amount, $3.4 million is related to $155 million of ARM securities
that are indexed to the one-year U.S. Treasury index and which, as a group,
prepaid at an annualized rate of 49% during October and had a yield below the
Company's cost of funds. The Company believes that by selecting these specific
ARM securities for sale, it not only increased its liquidity, but it improved
the future return on its ARM securities portfolio. Lastly, the Company financed
the majority of its whole loans and commitments to purchase whole loans by
issuing $1.1 billion of AAA rated notes, callable monthly, in a securitized
financing transaction in the fourth quarter of 1998. This financing benefited
the Company by providing the Company with a capital efficient method to finance
its whole loan assets over year end and allows the Company to call the
transaction and refinance the loans at a lower interest rate in early 1999 if
market conditions improve. However, the cost of this financing was greater than
current financing rates available to the Company for whole loans and therefore
adversely affected earnings in the fourth quarter of 1998 and possibly will
continue to do so during the first half of 1999. All of these measures were
successful in maintaining the Company's liquidity throughout the fourth quarter
of 1998 and the Company entered 1999 with a much improved liquidity level.

FINANCIAL CONDITION

At December 31, 1998, the Company held total assets of $4.345 billion, $4.268
billion of which consisted of ARM assets. That compares to $4.691 billion in
total assets and $4.639 billion of ARM assets at December 31, 1997. 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, 1998, 95.9% 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 currently owned by the Company, 90.0% are in the
form of adjustable-rate pass-through certificates or ARM loans. The remainder
are floating rate classes of CMOs (5.8%) or investments in floating rate classes
of CBOs (4.2%) backed primarily by mortgaged-backed securities.

20

The following table presents a schedule of ARM assets owned at December 31, 1998
and December 31, 1997 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)

December 31, 1998 December 31, 1997
-------------------------- ---------- -----------
Carrying Portfolio Carrying Portfolio
Value Mix Value Mix
-------------- ---------- ---------- ----------

HIGH QUALITY:
FHLMC/FNMA . . . . . . . . $ 2,072,871 48.6% $3,117,937 67.2%
Privately Issued:
AAA/Aaa Rating . . . . . 1,398,659 (1) 32.8 476,615 10.3
AA/Aa Rating . . . . . . 597,493 14.0 782,206 16.8
-------------- ---------- ---------- ----------
Total Privately Issued 1,996,152 46.8 1,258,821 27.1
-------------- ---------- ---------- ----------

Total High Quality . . 4,069,023 95.4 4,376,758 94.3
-------------- ---------- ---------- ----------

OTHER INVESTMENT:
Privately Issued:
A Rating . . . . . . . . 40,591 1.0 115,055 2.5
BBB/Baa Rating . . . . . 88,273 2.1 17,625 0.4
BB/Ba Rating and Other . 44,120 (1) 0.9 10,269 0.2
Whole loans. . . . . . . . 26,410 0.6 118,987 2.6
-------------- ---------- ---------- ----------
Total Other Investment 199,394 4.6 261,936 5.7
-------------- ---------- ---------- ----------

Total ARM Portfolio. . $ 4,268,417 100.0% $4,638,694 100.0%
============== ========== ========== ==========

- --------------
(1) AAA Rating category includes $1.020 billion of whole loans that have
been credit enhanced by an insurance policy purchased from a third-party and
credit support from an unrated subordinated certificate for $32.4 million
included in BB/Ba Rating and Other category and that are held as collateral for
callable AAA notes.

As of December 31, 1998, the Company had reduced the cost basis of its ARM
securities by a total of $1,242,000 due to potential future credit losses (other
than temporary declines in fair value). The Company is providing for potential
future credit losses on two securities that have an aggregate carrying value of
$11.8 million, which represent less than 0.3% of the Company's total portfolio
of ARM assets. Although both of these assets continue to perform, there is only
minimal remaining credit support to mitigate the Company's exposure to potential
future credit losses.

Additionally, during 1998, the Company recorded a $762,000 provision for
potential credit losses on its loan portfolio, although no actual losses have
been realized in the loan portfolio to date. As of December 31, 1998, the
Company's ARM loan portfolio included eight loans that are considered seriously
delinquent (60 days or more delinquent) with an aggregate balance of $5.0
million. The average original effective loan-to-value ratio on these eight
delinquent loans is approximately 62%. The Company estimates that the
realizable value of each of the single family homes backing these loans to be
more than the value of the individual loans and, therefore, the Company does not
expect to realize a loss on any of these delinquent loans. The Company's credit
reserve policy regarding ARM loans is to record a monthly provision of 0.15%
(annualized rate) on the outstanding principal balance of loans (including loans
securitized by the Company for which the Company has retained first loss
exposure), subject to adjustment on certain loans or pools of loans based upon
factors such as, but not limited to, age of the loans, borrower payment history,
low loan-to-value ratios and quality of underwriting standards applied by the
originator.

21

The following table classifies the Company's portfolio of ARM assets by type of
interest rate index.

ARM ASSETS BY INDEX
(Dollar amounts in thousands)

December 31, 1998 December 31, 1997
---------------------- ----------------------
Carrying Portfolio Carrying Portfolio
Value Mix Value Mix
---------- ---------- ---------- ----------

ARM ASSETS:
INDEX:
One-month LIBOR. . . . . . . . . . . $ 556,574 13.0% $ 115,198 2.5%
Three-month LIBOR. . . . . . . . . . 181,143 4.2 31,215 0.7
Six-month LIBOR. . . . . . . . . . . 939,824 22.0 1,489,802 32.1
Six-month Certificate of Deposit . . 313,268 7.3 278,386 6.0
Six-month Constant Maturity Treasury 49,023 1.2 66,669 1.4
One-year Constant Maturity Treasury. 1,479,054 34.7 2,271,914 49.0
Cost of Funds. . . . . . . . . . . . 268,486 6.3 385,510 8.3
---------- ---------- ---------- ----------
3,787,372 88.7 4,638,694 100.0
---------- ---------- ---------- ----------

HYBRID ARM ASSETS . . . . . . . . . . . . 481,045 11.3 - -
---------- ---------- ---------- ----------
$4,268,417 100.0% $4,638,694 100.0%
========== ========== ========== ==========

The ARM portfolio had a current weighted average coupon of 7.28% at December 31,
1998. This consisted of an average coupon of 6.96% on the hybrid portion of the
portfolio and an average coupon of 7.32% on the rest of the portfolio. If the
non-hybrid portion of the portfolio had been "fully indexed," the weighted
average coupon would have been approximately 6.79%, based upon the current
composition of the portfolio and the applicable indices. As of December 31,
1997, the ARM portfolio had a weighted average coupon of 7.56%. If the ARM
portfolio had been "fully indexed," the weighted average coupon would have been
approximately 7.64%, based upon the composition of the portfolio and the
applicable indices at that time. The Company did not own any hybrids as of
December 31, 1997. The lower average coupon on the ARM portfolio as of the end
of 1998 compared to 1997 is reflective of the overall lower interest rates in
the U.S. economy during these respective periods.

At December 31, 1998, the current yield of the ARM assets portfolio was 5.86%,
compared to 6.38% as of December 31, 1997, with an average term to the next
repricing date of 253 days as of December 31, 1998, compared to 110 days as of
December 31, 1997. The increase in the number of days until the next repricing
of the ARMs is primarily due to the hybrid loans acquired by the Company during
1998, which, in general, do not reprice for three to five years from their
origination date and have an average remaining fixed rate period of 4.3 years.
The current yield includes the impact of the amortization of applicable premiums
and discounts, the cost of hedging, the amortization of the deferred gains from
hedging activity and the impact of principal payment receivables.

The reduction in the yield as of December 31, 1998, compared to December 31,
1997, is primarily because of a combination of a lower average interest coupon
on the ARM portfolio by 0.28%, as stated above, and the higher rate of ARM
portfolio prepayments as of the end of 1998 compared to the end of 1997. During
the fourth quarter of 1998 the rate of prepayments had slowed to 29%, but this
was higher than the 24% experienced during the fourth quarter of 1997. The
higher level of prepayments increased the amount of premium amortization expense
and increased the impact of non-interest earning assets in the form of principal
payment receivables. Higher premium amortization and a higher balance of
principal payment receivables decreased the ARM portfolio yield by 0.24% as of
the end of 1998 compared to the end of 1997.

22

The following table presents various characteristics of the Company's ARM and
Hybrid ARM loan portfolio as of December 31, 1998. This information pertains to
both the loans held for securitization and the loans held as collateral for the
callable AAA notes payable.

ARM AND HYBRID ARM LOAN PORTFOLIO CHARACTERISTICS

Average High Low
--------- ----------- ------

Unpaid principal balance. $277,276 $3,450,000 $ 278
Coupon rate on loans. . . 7.50% 9.63% 5.00%
Pass-through rate . . . . 7.15% 9.23% 4.73%
Pass-through margin . . . 2.20% 5.18% 0.48%
Lifetime cap. . . . . . . 13.04% 16.75% 9.75%
Original Term (months). . 333 480 120
Remaining Term (months) . 319 358 93

Geographic Distribution (Top 5 States): Property type:
California . . . . . . . 21.87% Single-family 65.23%
Florida. . . . . . . . . 12.96 DeMinimus PUD 20.00
Georgia. . . . . . . . . 7.06 Condominium 9.59
New York . . . . . . . . 6.96 Other 5.18
Colorado . . . . . . . . 4.42

Occupancy status:. . . . . Loan purpose:
Owner occupied . . . . . 84.14% Purchase 57.60%
Second home. . . . . . . 11.38 Cash out refinance 23.78
Investor . . . . . . . . 4.48 Rate & term refinance 18.62

Documentation type:. . . . Periodic Cap:
Full/Alternative . . . . 95.73% None 49.04%
Other. . . . . . . . . . 4.27 2.00% 49.33
0.50% 1.63
Average effective original
loan-to-value: . . . . . . 67.55%

During the year ended December 31, 1998, the Company purchased $1.502 billion of
ARM securities, 93.7% of which were High Quality assets, and $1.092 billion of
ARM loans generally originated to "A" quality underwriting standards or seasoned
loans with over five years of good payment history and/or low loan-to-value
ratios. Of the ARM assets acquired during 1998, approximately 33% were Hybrid
ARMs, 32% were indexed to LIBOR, 13% were indexed to U.S. Treasury bill rates,
12% were indexed to a Cost of Funds Index, 9% were indexed to a Certificate of
Deposit Index and the remaining 1% to other indices. During 1998, the Company
began the acquisition of Hybrid ARM assets that have an interest rate that is
fixed for an initial period of time, generally 3 to 5 years, and then convert to
an adjustable-rate for the balance of the term of the loan. The Company
emphasized purchasing assets during 1998 at substantially lower prices relative
to par in order to reduce the potential impact of future prepayments. As a
result, the Company emphasized the acquisition of ARM and Hybrid ARM loans and
high quality floating rate collateralized mortgage and bond obligations. In
doing so, the average premium paid for ARM assets acquired in 1998 was 1.09% of
par as compared to 3.29% of par in 1997 when the Company emphasized the purchase
of seasoned ARM assets.

The Company sold ARM assets in the amount of $932.3 million at a net loss of
$278,000 during 1998. As discussed earlier, a large portion of these sales
occurred in the fourth quarter during a period of time when liquidity was a
problem for the mortgage finance industry. During this period, the Company sold
$421.2 million of ARM securities at a net loss of $4.1 million. During the
prior nine months, the Company had sold $511.1 million of ARM assets at a net
gain of $3.8 million. These sales during the first nine months of 1998 reflect
the Company's desire to manage the portfolio with a view to enhancing the total
return of the portfolio. The Company monitors the performance of its individual
ARM assets and generally sells an asset when there is an opportunity to replace
it with an ARM asset that has an expected higher long-term yield or more
attractive interest rate characteristics. The Company is presented with
investment opportunities in the ARM assets market on a daily basis and
management evaluates such opportunities against the performance of its existing
portfolio. At times, the Company is able to identify opportunities that it
believes will improve the total return of its portfolio by replacing selected
assets. In managing the portfolio, the Company may realize either gains or
losses in the process of replacing selected assets.

23

For the quarter ended December 31, 1998, the Company's mortgage assets paid down
at an approximate average annualized constant prepayment rate of 29% compared to
24% during the same period of 1997. The annualized constant prepayment rate
averaged approximately 31% during the full year of 1998 compared to 22% during
1997. When prepayment experience exceeds expectations due to sustained
increased prepayment activity, the Company has to amortize its premiums over a
shorter time period, resulting in a reduced yield to maturity on the Company's
ARM assets. Conversely, if actual prepayment experience is less than the
assumed constant prepayment rate, the premium would be amortized over a longer
time period, resulting in a higher yield to maturity. The Company monitors its
prepayment experience on a monthly basis in order to adjust the amortization of
the net premium, as appropriate.

The fair value of the Company's portfolio of ARM assets classified as
available-for-sale declined by 2.10% from a negative adjustment of 0.52% of the
portfolio as of December 31, 1997, to a negative adjustment of 2.62% as of
December 31, 1998. This price decline was primarily because of a decline in the
levels of liquidity in the mortgage market, the impact of market difficulties in
financing mortgage assets, a widening of credit spreads relative to treasury
yields due to uncertainties regarding future economic activity in the U.S. and
global economies and because of increased future prepayment expectations which
have the effect of shortening the average life of the Company's ARM assets and
decreasing their fair value. The amount of the negative adjustment to fair
value on the ARM assets classified as available-for-sale increased from $21.7
million as of December 31, 1997, to $83.2 million as of December 31, 1998. As
of December 31, 1998, all of the Company's ARM securities are classified as
available-for-sale and are carried at their fair value.

The Company has purchased Cap Agreements in order to limit its exposure to risks
associated with the lifetime interest rate caps of its ARM assets should
interest rates rise above specified levels. The Cap Agreements act to reduce
the effect of the lifetime or maximum interest rate cap limitation. The Cap
Agreements purchased by the Company will allow the yield on the ARM assets to
continue to rise in a high interest rate environment just as the Company's cost
of borrowings would continue to rise, since the borrowings do not have any
interest rate cap limitation. At December 31, 1998, the Cap Agreements owned by
the Company had a remaining notional balance of $4.026 billion with an average
final maturity of 2.3 years, compared to a remaining notional balance of $4.156
billion with an average final maturity of 3.1 years at December 31, 1997.
Pursuant to the terms of the Cap Agreements, the Company will receive cash
payments if the one-month, three-month or six-month LIBOR index increases above
certain specified levels, which range from 7.50% to 13.00% and average
approximately 10.10%. The fair value of these Cap Agreements also tends to
increase when general market interest rates increase and decrease when market
interest rates decrease, helping to partially offset changes in the fair value
of the Company's ARM assets. At December 31, 1998, the fair value of the Cap
Agreements was $1.5 million, $6.8 million less than the amortized cost of the
Cap Agreements.

24

The following table presents information about the Company's Cap Agreement
portfolio as of December 31, 1998:

CAP AGREEMENTS STRATIFIED BY STRIKE PRICE
(Dollar amounts in thousands)

Hedged Weighted Cap Agreement Weighted
ARM Assets Average Notional Average
Balance (1) Life Cap Balance (2) Strike Price Remaining Term
- ------------ --------- --------------- ------------- --------------

$ 439,159 9.12% $ 433,261 7.50% 1.3 Years
533,267 10.13 534,804 8.00 3.3
175,811 10.70 181,896 8.50 1.2
276,916 11.22 274,910 9.00 1.0
144,468 11.38 144,819 9.50 1.8
318,654 11.78 315,879 10.00 3.4
428,068 12.09 432,183 10.50 1.9
363,355 12.48 361,297 11.00 2.9
553,091 13.06 554,112 11.50 3.5
344,475 14.20 538,616 12.00 2.1
49,410 16.41 164,969 12.50 1.4
- - 89,283 13.00 1.1
- ------------ --------- --------------- ------------- --------------
$ 3,626,674 11.70% $ 4,026,029 10.10% 2.3 Years
============ ========= =============== ============= ==============

- ------------
(1) Excludes ARM assets that do not have life caps or are hybrids that are
match funded during a fixed rate period, in accordance with the Company's
investment policy.
(2) As of December 31, 1998, the Company was $399.4 million over hedged,
primarily because of the ARM asset sales that occurred during the fourth quarter
of 1998. The Company has retained these Cap Agreements to hedge its future
acquisitions which it expects to make during 1999. The retained Cap Agreements
have a carrying value of $0.

As of December 31, 1998, the Company was a counterparty to nineteen interest
rate swap agreements ("Swaps") having an aggregate notional balance of $1.473
billion. As of year-end, these Swaps had a weighted average remaining term of
16.5 months. In accordance with these Swaps, the Company will pay a fixed rate
of interest during the term of these Swaps and receive a payment that varies
monthly with the one-month LIBOR rate. As a result of entering into these
Swaps, the Company has reduced the interest rate variability of its cost to
finance its ARM assets by increasing the average period until the next repricing
of its borrowings from 26 days to 204 days. Fourteen of these Swaps were
entered into in connection with the Company's acquisition of Hybrid ARM loans
and commitments to purchase Hybrid ARM loans. These fourteen Swaps that hedge
the fixed rate portion of the Company's Hybrid ARM loans (to within one year of
the first interest rate reset) had a notional balance of $523 million at
year-end and an average maturity of 44.0 months. The other five swaps with a
notional balance of $950 million were entered into for the purpose of
lengthening the average next re-pricing date of the Company's borrowings to more
closely match the re-pricing characteristics of the Company's ARM assets. These
five swaps mature during the first quarter of 1999.

RESULTS OF OPERATIONS - 1998 COMPARED TO 1997

For the year ended December 31, 1998, the Company's net income was $22,695,000,
or $0.75 per share (Basic EPS), based on a weighted average of 21,488,000 shares
outstanding. That compares to $41,402,000, or $1.95 per share (Basic EPS),
based on a weighted average of 18,048,000 shares outstanding for the year ended
December 31, 1997. Net interest income for the year totaled $31,040,000,
compared to $49,064,000 for the same period in 1997. Net interest income is
comprised of the interest income earned on portfolio assets less interest
expense from borrowings. During 1998, the Company recorded a net loss on the
sale of ARM securities of $278,000 as compared to a gain of $1,189,000 during
1997. Additionally, during 1998, the Company reduced its earnings and the
carrying value of its ARM assets by reserving $2,032,000 for potential credit
losses, compared to $886,000 during 1997. During 1998, the Company incurred
operating expenses of $6,035,000, consisting of a base management fee of
$4,142,000, a performance-based fee of $759,000 and other operating expenses of
$1,134,000. During 1997, the Company incurred operating expenses of $7,965,000,
consisting of a base management fee of $3,664,000, a performance-based fee of
$3,363,000 and other operating expenses of $938,000. Total operating expenses
decreased as a percentage of average assets to 0.13% for 1998, compared to 0.21%
for 1997, primarily due to the elimination of the performance-based fee during
the last three quarters of 1998.

25

The Company's return on average common equity was 4.80% for the year ended
December 31, 1998 compared to 12.72% for the year ended December 31, 1997. The
primary reasons for the lower return on average common equity are the Company's
lower interest rate spread, discussed further below and the net loss recorded in
1998 on the sale of ARM securities, which were partially offset by lower
operating expenses.

The table below highlights the historical trend and the components of return on
average common equity (annualized) and the 10-year U. S. Treasury average yield
during each respective quarter which is applicable to the computation of the
performance fee:

COMPONENTS OF RETURN ON AVERAGE COMMON EQUITY (1)

ROE in
Excess of
Net Gain (Loss) Net 10-Year 10-Year
Interest Provision on ARM G & A Performance Preferred Income/ US Treas. US Treas.
For The Income/ For Losses/ Sales/ Expense (2)/ Fee/ Dividend/ Equity Average Average
Quarter Ended Equity Equity Equity Equity Equity Equity (ROE) Yield Yield
- ------------- --------- ------------ ------- ------------- ------------ ---------- ---------- ---------- ----------

Mar 31, 1996. 13.37% - 0.03% 1.04% 1.27% - 11.08% 5.90% 5.18%
Jun 30, 1996. 13.14% - - 1.00% 0.92% - 11.22% 6.72% 4.50%
Sep 30, 1996. 13.42% 0.34% 0.88% 1.03% 1.07% - 11.86% 6.78% 5.08%
Dec 31, 1996. 14.99% 1.32% 1.38% 1.46% 1.23% - 12.37% 6.35% 6.02%
Mar 31, 1997. 18.85% 0.32% 0.01% 1.65% 1.43% 2.07% 13.40% 6.55% 6.85%
Jun 30, 1997. 19.48% 0.34% 0.03% 1.81% 1.25% 2.67% 13.45% 6.71% 6.74%
Sep 30, 1997. 17.66% 0.30% 0.45% 1.64% 1.24% 2.23% 12.70% 6.26% 6.44%
Dec 31, 1997. 15.62% 0.33% 1.06% 1.59% 1.01% 2.12% 11.63% 5.92% 5.71%
Mar 31, 1998. 14.13% 0.48% 1.89% 1.62% 0.94% 2.06% 10.91% 5.60% 5.31%
Jun 30, 1998. 9.15% 0.53% 1.76% 1.58% 0.00% 1.96% 6.83% 5.60% 1.23%
Sep 30, 1998. 6.82% 0.66% 0.89% 1.54% 0.00% 1.97% 3.54% 5.24% -1.70%
Dec 31, 1998. 7.27% 0.76% -4.88% 1.57% 0.00% 2.01% -1.95% 4.66% -6.61%

- -------------
(1) Average common equity excludes unrealized gain (loss) on available-for-sale ARM securities.
(2) Excludes performance fees.

The decline in the Company's return on common equity from the fourth quarter of
1997 to the fourth quarter of 1998 is primarily due to the decline in the net
interest spread between the Company's interest-earning assets and
interest-bearing liabilities, an increase in the Company's provision for losses
and the impact of a net loss on ARM sales as compared to a net gain on ARM
sales. This decline in net return on common equity was partially offset by the
elimination of the performance-based fee. The decline in the Company's return
on common equity from the third quarter of 1998 to the fourth quarter of 1998 is
primarily due to the impact of a net loss on ARM sales as compared to a net gain
on ARM sales and an increase in the Company's provision for losses. This
decline was partially offset by an increase in the net interest spread between
the Company's interest-earning assets and interest-bearing liabilities.

26

The following table presents the components of the Company's net interest income
for the years ended December 31, 1998 and 1997:

COMPARATIVE NET INTEREST INCOME COMPONENTS
(Dollar amounts in thousands)

1998 1997
--------- ---------

Coupon interest income on ARM assets $335,983 $271,170
Amortization of net premium. . . . . (46,101) (21,343)
Amortization of Cap Agreements . . . (5,444) (5,313)
Amort. of deferred gain from hedging 1,889 1,992
Cash and cash equivalents. . . . . . 705 1,215
--------- ---------
Interest income. . . . . . . . . . 287,032 247,721
--------- ---------

Reverse repurchase agreements. . . . 251,462 197,006
Callable AAA notes payable . . . . . 2,811 -
Other borrowings . . . . . . . . . . 632 969
Interest rate swaps. . . . . . . . . 1,087 682
--------- ---------
Interest expense . . . . . . . . . 255,992 198,657
--------- ---------

Net interest income. . . . . . . . . $ 31,040 $ 49,064
========= =========

As presented in the table above, the Company's net interest income decreased by
$18.0 million in 1998 compared to 1997, primarily because the amortization of
net premium increased by $24.8 million. In 1998 the amortization of net premium
was