THORNBURG MORTGAGE INC - 10-K Annual Report

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

FORM 10-K

(MARK ONE)

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

FOR THE FISCAL YEAR ENDED: DECEMBER 31, 2001

OR

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

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

COMMISSION FILE NUMBER: 001-11914

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

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

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

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

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

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

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

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

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

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

DOCUMENTS INCORPORATED BY REFERENCE:

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

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

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PART I

ITEM 1. BUSINESS

GENERAL

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

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

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

OPERATING POLICIES AND STRATEGIES

Investment Strategies

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

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

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Our mortgage assets portfolio may consist of either U.S. Government agency or
privately issued (generally publicly registered) mortgage pass-through
securities, multi-class pass-through securities, collateralized mortgage
obligations ("CMOs"), collateralized bond obligations ("CBOs") which are
generally backed by high quality mortgage-backed securities ("MBS"), ARM loans,
fixed rate MBS that have an expected duration of one year or less or short-term
investments that either mature within one year or have an interest rate that
reprices within one year. We also invest in hybrid ARM assets ("Hybrid ARMs").
Hybrid ARMs are typically 30-year loans that have a fixed rate of interest for
an initial period, generally 3 to 10 years, and then convert to an adjustable
rate for the balance of their term. We limit our ownership of Hybrid ARMs with
fixed rate periods of greater than five years to no more than 10% of our total
assets.

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

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

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

(3) securities that are unrated or whose ratings have not been updated but
are determined to be of comparable quality (by the rating standards of
at least one of the Rating Agencies) to a High Quality rated mortgage
security, as determined by the Manager and approved by our Board of
Directors; or

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

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

(1) adjustable or variable rate pass-through certificates, multi-class
pass-through certificates or CMOs backed by loans on single-family,
multi-family, commercial or other real estate-related properties so
long as they are rated at least Investment Grade at the time of
purchase. "Investment Grade" generally means a security rating of
"BBB" or "Baa" or better by at least one of the Rating Agencies;

(2) ARM loans collateralized by first liens on single-family residential
properties, generally underwritten to "A" quality standards, and
acquired for the purpose of future securitization;

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

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

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

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

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

Acquisition and Securitization of ARM and Hybrid ARM Loans

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

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believe that the acquisition and origination of ARM loans for securitization
benefits us by providing: (i) greater control over the quality and types of ARM
assets acquired; (ii) the ability to acquire ARM assets at lower prices so that
the amount of the premium to be amortized will be reduced in the event of
prepayment; (iii) additional sources of new whole-pool ARM assets; and (iv)
potentially higher yielding investments in our portfolio.

Bulk Acquisitions and Correspondent Lending

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

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

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

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

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

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Direct Loan Origination

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

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

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

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

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

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

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

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Securitization of ARM Loans

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

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

Financing Strategies

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

Our borrowings are primarily at short term rates and in the form of reverse
repurchase agreements using our ARM securities as collateral. Reverse repurchase
agreements involve a simultaneous sale of pledged assets to a lender at an
agreed-upon price in return for the lender's agreement to resell the same assets
back to us at a future date (the maturity of the borrowing) at a higher price.
The price difference is the cost of borrowing under these agreements. Generally,
upon repayment of each reverse repurchase agreement, we immediately pledge the
ARM assets used to collateralize the financing to secure a new reverse
repurchase agreement. In the event of the insolvency or bankruptcy of a lender
during the term of a reverse repurchase agreement, the lender, under the Federal
Bankruptcy Code, may be allowed to assume or reject the agreement to resell the
assets. If a bankrupt lender rejects its obligation to resell pledged assets to
us, our claim against the lender for the resulting damages may be treated as one
of many unsecured claims against the lender's assets. These claims would be
subject to significant delay and, if and when payments are received, they may be
substantially less than the damages that we actually suffer. To mitigate this
risk, we enter into collateralized borrowings with only financially sound
institutions approved by our Board of Directors, including a majority of
unaffiliated directors, and monitor the financial condition of such institutions
on a regular, periodic basis.

We also finance the purchase of ARM assets by issuing debt obligations in the
capital markets, which are collateralized by securitized pools of our ARM assets
that are placed in a trust. The trust pays the principal and interest payments
on the debt out of the cash flows received on the collateral. Using such a
structure enables us to issue debt that will not be subject to margin calls once
the debt obligation has been issued.

We also enter into financing facilities for whole loans. A whole loan is the
actual mortgage loan evidenced by a note and secured by a mortgage or deed of
trust. We use these credit lines to finance our acquisition of whole loans while
we are accumulating loans for securitization or until we arrange more permanent
financing in a capital markets, collateralized debt transaction.

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

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

Hedging Strategies

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

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

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

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

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

In the past, the ARM assets that we held were generally purchased at prices
greater than par. We amortize the premiums paid for these assets over their
expected lives using the level yield method of accounting. To the extent that
the prepayment rate on our ARM assets differs from expectations, our net
interest income will be affected. Prepayments generally increase when mortgage
interest rates fall below the interest rates on ARM loans. To the extent there
is an increase in prepayment rates, resulting in a shortening of the expected
lives of our ARM assets, our net income and, therefore, the amount available for
dividends could be adversely affected. To mitigate the adverse effect of an
increase in prepayments on our ARM assets, we emphasize the purchase of ARM
assets at prices at or below par. Our portfolio of ARM assets is currently held
at a net premium of 0.94%, down from 2.83% as of the end of 1997. We may also
purchase limited amounts of "principal only" mortgage derivative assets backed
by either fixed rate mortgages or ARM assets as a hedge against the adverse
effect of increased prepayments. To date, we have not purchased any "principal
only" mortgage derivative assets.

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

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

The hedging transactions that we currently use generally are designed to protect
our net interest income during periods of changing market interest rates. We do
not intend to hedge for speculative purposes. Further, no hedging strategy can
completely insulate us from risk, and certain of the federal income tax
requirements that we must satisfy to qualify as a REIT limit our ability to
hedge, particularly with respect to hedging against periodic cap risk. We
carefully monitor and may have to limit our hedging strategies to ensure that we
do not realize excessive hedging income or hold hedging assets having excess
value in relation to total assets. See "Federal Income Tax Considerations -
Requirements for Qualification as a REIT."

Operating Restrictions

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

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

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

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

PORTFOLIO OF MORTGAGE ASSETS

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

PASS-THROUGH CERTIFICATES

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

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

Freddie Mac ARM Programs

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

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

Fannie Mae ARM Programs

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

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

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

Privately Issued ARM Pass-Through Certificates

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

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

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

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

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

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

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

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

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

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

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

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

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

ARM AND HYBRID ARM LOANS

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

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

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

RISK FACTORS

FORWARD-LOOKING STATEMENTS

In accordance with the Private Securities Litigation Reform Act of 1995 (the
"1995 Act"), we can obtain a "safe harbor" for forward-looking statements by
identifying those statements and by accompanying those statements with
cautionary statements, which identify factors that could cause actual results to
differ from those in the forward-looking statements. Statements that are not
historical facts, including statements about our beliefs or expectations, are
forward-looking statements. The words "believe," "anticipate," "intend," "aim,"
"expect," "will," and similar words identify forward-looking statements. Such
statements are not guarantees of future performance, events or results and
involve potential risks and uncertainties. Accordingly, our actual results may
differ from our current expectations, estimates and projections. Readers should
understand that many factors govern whether any forward-looking statement will
be or can be achieved. Any one of those factors could cause actual results to
differ materially from those projected.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

AN INCREASE IN PREPAYMENT RATES MAY ADVERSELY AFFECT OUR PROFITABILITY.

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

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

15

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

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

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

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

OUR STRATEGY INVOLVES LEVERAGE.

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

o OUR LEVERAGE MAY CAUSE SUBSTANTIAL LOSSES.

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

o short-term interest rates increase;

o the market value of our ARM assets decreases;

o interest rate volatility increases; or

o the availability of financing in the market decreases.

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

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

o LIQUIDATION OF COLLATERAL MAY JEOPARDIZE OUR REIT STATUS.

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

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

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

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

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

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

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

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

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

o the movement of interest rates;

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

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

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

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

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

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

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

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WE HAVE NOT ESTABLISHED A MINIMUM DIVIDEND PAYMENT LEVEL.

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

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

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

WE ARE DEPENDENT ON OUR KEY PERSONNEL.

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

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

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

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

WE AND OUR SHAREHOLDERS ARE SUBJECT TO CERTAIN TAX RISKS.

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

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

18

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

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

o WE HAVE CERTAIN DISTRIBUTION REQUIREMENTS.

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

o WE ARE ALSO SUBJECT TO OTHER TAX LIABILITIES.

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

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

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

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

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

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

19

WE MAY CHANGE OUR POLICIES WITHOUT SHAREHOLDER APPROVAL.

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

COMPETITION

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

EMPLOYEES

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

THE MANAGEMENT AGREEMENT

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

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

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

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

20

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

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

FEDERAL INCOME TAX CONSIDERATIONS

GENERAL

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

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

REQUIREMENTS FOR QUALIFICATION AS A REIT

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

Ownership of Common Stock

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

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

Nature of Assets

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

21

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

Sources of Income

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

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

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

Distributions

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

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

TAXATION OF SHAREHOLDERS

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

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

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

22

TAXATION OF THE COMPANY

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

ITEM 2. PROPERTIES

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

ITEM 3. LEGAL PROCEEDINGS

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

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

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

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PART II

ITEM 5. MARKET FOR COMMON EQUITY AND RELATED SHAREHOLDER MATTERS

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

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

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

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

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

DIVIDEND REINVESTMENT PLAN

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

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ITEM 6. SELECTED FINANCIAL DATA

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

OPERATIONS STATEMENT HIGHLIGHTS

BALANCE SHEET HIGHLIGHTS

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

(2) Before unrealized market value adjustments.

25

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

CRITICAL ACCOUNTING POLICIES

The Company's financial statements are prepared in conformity with generally
accepted accounting principles, many of which require the use of estimates and
assumptions. In accordance with recent Securities and Exchange Commission
guidance, those material accounting policies that we believe are the most
critical to an investor's understanding of the Company's financial results and
condition and require complex management judgment have been expanded and
discussed below.

o Fair Value. The Company records its ARM securities and Cap and Swap
Agreements at fair value. The fair values of the Company's ARM securities
and Cap and Swap Agreements are generally based on market prices provided
by certain dealers who make markets in these financial instruments or
third-party pricing services. If the fair value of an ARM security is not
reasonably available from a dealer or a third-party pricing service,
management estimates the fair value based on characteristics of the
security it receives from the issuer and available market information. The
fair values reported reflect estimates and may not necessarily be
indicative of the amounts the Company could realize in a current market
exchange.

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

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

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

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

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

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FINANCIAL CONDITION

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

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

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

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

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

27

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

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

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

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

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

28

As of December 31, 2000, the ARM portfolio had a weighted average coupon of
7.75%. This consisted of an average coupon of 6.77% on the hybrid portion of the
portfolio and an average coupon of 8.11% on the rest of the portfolio. If the
non-hybrid portion of the portfolio had been "fully indexed," the weighted
average coupon of the ARM portfolio would have been approximately 7.46%, based
upon the composition of the portfolio and the applicable indices at that time.
The lower average interest coupon on the ARM portfolio as of December 31, 2001
compared to the end of 2000 is reflective of Federal Reserve Board interest rate
decreases that have been occurring since January 2001. The average interest rate
on the ARM portion of the portfolio is expected to decrease during 2002 until it
reaches the "fully indexed" rate.

At December 31, 2001, the current yield of the ARM assets portfolio was 5.09%,
compared to 7.06% as of December 31, 2000, with an average term to the next
repricing date of 617 days as of December 31, 2001, compared to 308 days as of
December 31, 2000. The non-hybrid portion of the portfolio had an average term
to the next repricing of 89 days and the hybrid portion had an average term to
the next repricing of 3.7 years at December 31, 2001. As of December 31, 2001,
Hybrid ARMs comprised 41.7% of the total ARM portfolio, compared to 25.4% as of
the end of 2000. The Company finances its Hybrid ARM portfolio with longer term
fixed-rate borrowings such that the duration mismatch of the Hybrid ARMs and the
corresponding borrowings is one year or less. Duration is a calculation that
measures the expected price volatility of financial instruments based on changes
in interest rates over time. By maintaining a duration mismatch of less than one
year, the price change of the Company's Hybrid ARM portfolio would be expected
to be a maximum of 1% for every 1% change in interest rates. As of December 31,
2001, the duration mismatch was approximately two months. The current yield
includes the impact of the amortization of applicable premiums and discounts and
the impact of principal payment receivables.

The decrease in the yield of 1.97% as of December 31, 2001, compared to December
31, 2000, is primarily due to the decreased weighted average interest rate
coupon discussed above, which decreased by 1.79%. The yield also declined as a
result of a higher level of net premium amortization, which had the effect of
lowering the yield by 0.13% and the impact of non-interest earning principal
payments receivables, which also increased during 2001, decreasing the portfolio
yield by 0.07%, as the average rate of ARM portfolio prepayments during fourth
quarter of 2001 increased to 29% Constant Prepayment Rate ("CPR") from the 19%
CPR during the first quarter of 2001 and 28% during the second quarter of 2001,
but down slightly from 30% during the third quarter of 2001. These unfavorable
factors that decreased the ARM portfolio yield were partially offset by the
elimination of the 0.02% effect of hedging cost from the Company's interest rate
spread computation. With the adoption of FAS 133, the Company carries all
hedging instruments at their fair value and records hedging income and expense
in net income as a separate item identified at "Hedging expense".

29

The following table presents various characteristics of the Company's ARM and
Hybrid ARM loan portfolio as of December 31, 2001. This information pertains to
loans held for securitization, loans held as collateral for the notes payable
and loans the Company has securitized for its own portfolio for which the
Company retained credit loss exposure. The combined amount of the loans included
in this information is $1.924 billion.

ARM AND HYBRID ARM LOAN PORTFOLIO CHARACTERISTICS

As of December 31, 2001, the Company serviced $477.9 million of its loans and
had 1,141 customer relationships. All of the loans serviced are held by the
Company in its portfolio in the form of securitized loans or loans held for
securitization for the Company's portfolio. The Company has not retained and
capitalized any servicing rights on loans sold.

30

During the year ended December 31, 2001, the Company purchased $2.671 billion of
ARM securities, 97.9% of which were High Quality assets and $1.185 billion of
ARM loans, generally originated to "A" quality underwriting standards. Of the
ARM assets acquired during 2001, approximately 51% were Hybrid ARMs, 23% were
fixed-rate, short-term securities, 14% were indexed to U.S. Treasury bill rates,
9% were indexed to LIBOR and 3% were indexed to a cost of funds index. The
following table compares the Company's ARM asset acquisition and origination
activity for each of the consecutive quarters of 2001, along with total activity
for 2001:

ARM ASSET ACQUISITIONS BY QUARTER
(Dollar Amounts in thousands)

Since 1997, the Company has emphasized purchasing assets at substantially lower
prices relative to par in order to reduce the potential impact of future
prepayments. As a result, the Company has emphasized the acquisition of ARM and
Hybrid ARM assets, high quality floating-rate collateralized mortgages and
short-term fixed-rate securities. In doing so, the average premium/(discount)
paid for ARM assets acquired in 2001 and for the years 2000, 1999 and 1998 was
0.12%, (0.42%), 0.45% and 1.09% of par, respectively, as compared to 3.29% of
par in 1997 when the Company emphasized the purchase of seasoned ARM assets. In
part, as a result of this strategy, the Company's unamortized net premium as a
percent of par decreased to 0.94% as of December 31, 2001, compared to 1.64% as
of December 31, 2000 and down from 2.83% as of the end of 1997.

During 2001, the Company securitized $1.219 billion of its ARM loans into a
series of privately-issued multi-class ARM securities. The Company retained, for
its ARM portfolio, all of the classes of the securities created. In addition,
during 2001, the Company swapped $23.2 million ARM loans for FNMA guaranteed
certificates. The Company securitizes the ARM loans that it acquires into ARM
securities for its own portfolio in order to reduce the cost of financing the
portfolio and in order to enhance the high quality and highly liquid
characteristics of its portfolio, thereby improving the Company's access to
mortgage finance markets. In doing so, the Company retains all of the economic
interest and risk of the loans, except those swapped for FNMA guaranteed
certificates, which it acquires and originates, although they are in the form of
securities. Of the securities created during 2001, 99.6% were at least
investment grade securities and 0.4% were subordinate securities that provide
credit support to the investment grade securities.

As of December 31, 2001, the Company had commitments to purchase $394.1 million
of ARM securities and $338.3 million ARM loans through its origination channels.

During 2001, the Company sold $108.1 million of ARM securities and $0.3 million
of fixed-rate loans that it had originated. During 2000, the Company sold $120.0
million of ARM assets. These sales consisted of securities and loans that
generally did not fit the Company's portfolio parameters.

31

For the quarter ended December 31, 2001, the Company's ARM mortgage assets paid
down at an approximate average annualized CPR of 29% compared to 18% for the
quarter ended December 31, 2000 and 30% for the quarter ended September 30,
2001. The annualized constant prepayment rate averaged approximately 27% during
the full year of 2001 compared to 17% during 2000. When prepayment experience
increases, 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 decreases, 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 increased by 2.12% from a negative adjustment of 2.28% of the
portfolio as of December 31, 2000, to a negative adjustment of 0.16% as of
December 31, 2001. This price increase was primarily due to the effect of
declining short-term interest rates and a steepening of the yield curve
(short-term interest rates declining relative to long-term interest rates). The
amount of the negative adjustment to fair value on the ARM assets classified as
available-for-sale decreased from $78.4 million as of December 31, 2000 to $8.5
million as of December 31, 2001. All of the Company's ARM securities are
classified as available-for-sale and are carried at their fair value.

The Company has designated its Cap Agreements as fair value hedges that are
intended to hedge the fair value of the lifetime interest rate cap component of
its ARM assets. The fair value of Cap Agreements tend 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, 2001, the fair value of the Company's Cap Agreements was
$0.4 million compared to a fair value of $1.3 million as of December 31, 2000.
During the third and fourth quarters of 2001, the change in the fair value of
the Cap Agreements compared to the change in the fair value of the hedged asset,
the lifetime interest rate cap component of the Company's ARM assets, did not
meet the effectiveness requirements of FAS 133. Therefore, during the last half
of 2001, the change in fair value of the Cap Agreements was recorded as a
hedging expense with no offsetting change recorded for the change in fair value
of the hedged asset. The Company recorded hedging ineffectiveness during 2001 in
the amount of $0.7 million, along with a reclassification to earnings of $0.6
million of the transition adjustment recorded in "Accumulated other
comprehensive income" on January 1, 2001. At December 31, 2001, the Cap
Agreements had a remaining notional balance of $2.254 billion with an average
final maturity of 1.5 years, compared to a remaining notional balance of $2.624
billion with an average final maturity of 2.3 years at December 31, 2000. The
Company also owns these Cap Agreements in order to mitigate exposure to changing
interest rates. They tend to limit the Company's exposure to risks associated
with the lifetime interest rate caps of its ARM assets should interest rates
rise above specified levels. These Cap Agreements act to reduce the effect of
the lifetime or maximum interest rate cap limitation. These 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. Pursuant to the terms of these 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 5.875% to
12.00% and average approximately 10.05%.

32

The following table presents information about the Company's Cap Agreement
portfolio as of December 31, 2001:

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

- -------------------
(1) Excludes ARM assets that do not have Life Caps or are hybrids that are
match funded during their fixed rate period, in accordance with the
Company's investment policy.

The Company enters into interest rate Swap Agreements in order to manage its
interest rate exposure when financing its ARM assets. The Company generally
borrows money based on short-term interest rates, either by entering into
borrowings with maturity terms of less than six months, and frequently one
month, or by entering into borrowings with longer maturity terms of one to two
years that reprice based on a frequency that is commonly one month, but has at
times been up to six months. The Company's ARM assets generally have an interest
rate that reprices based on frequency terms of one to twelve months. The
Company's Hybrid ARMs generally have an initial fixed interest rate period of
three to ten years. As a result, the Company's existing and forecasted
borrowings reprice to a new rate on a more frequent basis than do the Company's
ARM assets. When the Company enters into a Swap Agreement, it agrees to pay a
fixed rate of interest and to receive a variable interest rate , generally based
on LIBOR. These Swap Agreements have the effect of converting the Company's
variable-rate debt into fixed-rate debt over the life of the Swap Agreements.
Swap Agreements are used as a cost effective way to lengthen the average
repricing period of the Company's variable rate and short-term borrowings such
that the average repricing of the borrowings more closely matches the average
repricing of the Company's ARM assets.

As of December 31, 2001, the Company was counterparty to thirty-eight Swap
Agreements having an aggregate notional balance of $1.690 billion. These Swap
Agreements hedged the fixed interest rate period of Hybrid ARMs and had a
weighed average maturity of 2.8 years. As a result of entering into these Swap
Agreements, 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 45 days to 375 days. The average remaining fixed rate
term of the Company's Hybrid ARM assets as of December 31, 2001 was 3.7 years.
Further, the difference between the duration of Hybrid ARMs and the duration of
the borrowings funding Hybrid ARMs, as of December 31, 2001, was approximately
two months.

In accordance with FAS 133, all of these Swaps Agreements have been designated
as cash flow hedges and, as of December 31, 2001, are being carried on the
balance sheet at their negative fair value of $35.7 million. As of December 31,
2001, the fair value adjustment for Swap Agreements was a decrease to
"Accumulated other comprehensive income" in the amount of $34.1 million. Since
the Swap Agreements and the short-term borrowings they hedge have nearly
identical terms and characteristics with respect to the applicable index and
interest rate repricing dates, the Company has calculated the effectiveness of
this cash flow hedge to be approximately 100%. As a result of the calculated
effectiveness of approximately 100% to date, all changes in the unrealized gains
and losses on Swap Agreements have been recorded in "Accumulated other
comprehensive income" and are reclassified to earnings as interest expense is
recognized on the Company's hedged borrowings.

33

In addition, during December 2001 and January 2002, the Company entered into
five additional Swap Agreements for an initial notional amount of $770 million
that become effective in January 2002. These additional Swap Agreements hedge
the forecasted financing of Hybrid ARMs, including outstanding commitments to
purchase Hybrid ARMs as of December 31, 2001.

RESULTS OF OPERATIONS - 2001 COMPARED TO 2000

For the year ended December 31, 2001, the Company's net income was $58,662,000,
or $2.09 per share (Basis and Diluted EPS), based on a weighted average of
24,754,000 shares outstanding. That compares to $29,165,000, or $1.05 per share
(Basic and Diluted EPS), based on a weighted average of 21,506,000 shares
outstanding for the year ended December 31, 2000, a 99% increase in the
Company's earnings per share.

The Company's return on average common equity was 13.82% for the year ended
December 31, 2001 compared to 6.90% for the year ended December 31, 2000. During
the fourth quarter of 2001, the Company's return on equity rose to 17.31%,
compared to 13.94% during the third quarter of 2001. The Company's return on
equity improved in this past quarter compared to the prior quarter primarily
because the Company's net interest income continued to improve due to lower cost
of funds of the Company's borrowings and because the yield on the Company's ARM
portfolio is benefiting from acquisitions of loans and other ARM and Hybrid ARM
assets acquired at average prices close to par, replacing lower yielding ARM
assets that paid off.

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 that is applicable to the computation of the
performance fee:

COMPONENTS OF RETURN ON AVERAGE COMMON EQUITY (1)

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

(2) Excludes performance fees and net of loan servicing fees.

(3) Reflects implementation of FAS 133.

The increase in the Company's return on common equity in the fourth quarter of
2001, compared to the fourth quarter of 2000, is due to the improvement in the
net interest spread between the Company's interest-earning assets and
interest-bearing liabilities, a decrease in the Company's provision for losses,
and a decrease in the impact of the preferred dividend. These positive impacts
on the Company's return on equity were partially offset by the performance based
fee and an increase in hedging expense and other expenses.

34

The following table presents the components of the Company's net interest
income for the years ended December 31, 2001 and 2000:

COMPARATIVE NET INTEREST INCOME COMPONENTS
(Dollar amounts in thousands)

As presented in the table above, the Company's net interest income increased by
$42.1 million in 2001 compared to 2000. The most significant change was the
decline in interest expense of $53.5 million. The following two tables explain
the increase in net interest income in terms of volume and rate variances.

The following table presents the average balances for each category of the
Company's interest earning assets as well as the Company's interest bearing
liabilities, with the corresponding annualized effective rate of interest and
the related interest income or expense:

AVERAGE BALANCE, RATE AND INTEREST INCOME/EXPENSE TABLE
(Dollar amounts in thousands)

- --------------------
(1) Yield on Net Interest Earning Assets is computed by dividing annualized net
interest income by the average daily balance of interest earning assets.

35

The following table presents the total amount of change in interest
income/expense from the table above and presents the amount of change due to
changes in interest rates versus the amount of change due to changes in volume
(dollar amounts in thousands):

As a net result of the yield on the Company's interest-earning assets decreasing
to 5.92% during 2001 from 6.82% during 2000 and the Company's cost of funds
decreasing to 4.68% from 6.54%, its net interest income increased by
$42,135,000. This increase in net interest income is the combined result of a
favorable rate variance and favorable volume variance. There was a net favorable
rate variance of $33,871,000, which consisted of an unfavorable variance of
$37,409,000 resulting from the lower yield on the Company's ARM assets portfolio
and other interest-earning assets and a favorable variance of $71,280,000
resulting from the decrease in the Company's cost of funds. The higher average
amount of interest earning assets during 2001 produced a favorable volume
variance of $26,030,000, but this was partially offset by the higher average
balance of borrowings, which produced an unfavorable volume variance of
$17,766,000, resulting in a net favorable volume variance of $8,264,000. The
average balance of the Company's interest-earning assets was $4.706 billion
during 2001, compared to $4.253 billion during 2000, an increase of 10.6%.

36

The following table highlights the components of net interest spread and the
annualized yield on net interest-earning assets as of each applicable quarter
end:

COMPONENTS OF NET INTEREST SPREAD AND YIELD ON NET INTEREST EARNING ASSETS(1)
(Dollar amounts in millions)

---------------------
(1) Yield on Net Interest Earning Assets is computed by dividing annualized
net interest income for the applicable quarter by the average daily
balance of interest earning assets during the quarter.

(2) Yield adjustments include the impact of amortizing premiums and
discounts, the cost of hedging activities, the amortization of deferred
gains from hedging activities and the impact of principal payment
receivables. The following table presents these components of the yield
adjustments for the dates presented in the table above.

(3) The year-end cost of funds and net interest spread are commonly
effected by significant, but generally temporary, year-end pressures
that raise the Company's cost of financing mortgage assets over
year-end. The effect generally begins during the latter part of
November and continues through January.

COMPONENTS OF THE YIELD ADJUSTMENTS ON ARM ASSETS

The Company recorded net hedging expense during the fourth quarter of 2001 in
the amount of $213,000. This expense was calculated based on the requirements of
FAS 133, adopted by the Company as of January 1, 2001. At September 30, 2001,

37

the fair value of the Company's Cap Agreements was $209,000 compared to a fair
value of $431,000 as of December 31, 2001, an increase in fair value of
$221,000. The Company determined that the hedge utilizing Cap Agreements was not
effective during the fourth quarter and, as a result, the Company recorded the
change in fair value of the Cap Agreements as hedging income. During the fourth
quarter, the Company also reclassified to earnings $434,000 of the transition
adjustment recorded in "Accumulated other comprehensive income" on January 1,
2001, in connection with the implementation of FAS 133. For the year 2001, the
Company recorded hedging ineffectiveness in the amount of $758,000 and
reclassified to earnings $579,000 of the transition adjustment, for total
hedging expense of $1,337,000.

The Company's provision for estimated credit losses decreased in 2001 compared
to 2000, in part, because the Company decided to reduce its rate of providing
for losses on its whole loan credit exposure late in 2000. During the Company's
2000 third quarter review of the level of its allowance for loan losses and
after considering its identifiable loss exposure to delinquent loans and the
lack of any significant losses to date recorded in the portfolio, the Company
concluded that its allowance for loan losses had reached a level that it was
appropriate to reduce the rate at which the Company was recording provisions.
Since the commencement of acquiring whole loans in 1997, the Company has only
experienced losses on three loans, for the total amount of $174,000. In
addition, in November, the Company made the determination that virtually all of
its loans were expected to be securitized and that none of its loans were
expected to experience a loss prior to securitization. Therefore, the Company
discontinued its provision of estimated loan losses. The Company completed two
loan securitization transactions in November and December 2001 and transferred
the loan loss reserve associated with the securitized loans to the cost basis of
the resulting securities. The Company will continue to evaluate its estimated
credit losses on loans that are not expected to be securitized and for estimated
credit losses that become probable prior to securitization. As of December 31,
2001, the Company's whole loans, including those held as collateral for the
notes payable and those that the Company has securitized but retained credit
loss exposure, accounted for 34.0% of the Company's portfolio of ARM assets or
$1.924 billion.

As a REIT, the Company is required to declare dividends amounting to 85% of each
year's taxable income by the end of each calendar year and to have declared
dividends amounting to 90% of its taxable income for each year by the time it
files its applicable tax return and, therefore, generally passes through
substantially all of its earnings to shareholders without paying federal income
tax at the corporate level. As of December 31, 2001, the Company had met all of
the dividend distribution requirements of a REIT. Since the Company, as a REIT,
pays its dividends based on taxable earnings, the dividends may at times be more
or less than reported earnings. The following table provides a reconciliation
between the Company's earnings as reported based on generally accepted
accounting principles and the Company's taxable income before its common
dividend deduction:

RECONCILIATION OF REPORTED NET INCOME TO TAXABLE NET INCOME
(Dollar amounts in thousands)

38

For the year ended December 31, 2001, the Company's ratio of operating expenses
to average assets was 0.38% compared to 0.16% for the year 2000. The most
significant single increase to the Company's expenses was the performance based
fee of $6,716,000 that the Manager earned during 2001 as a result of the Company
achieving a return on shareholder equity in excess of the threshold as defined
in the Management Agreement. The Company's return on equity, prior to the effect
of the performance-based fee, was 15.6% whereas the threshold, the average
10-year treasury rate plus 1%, averaged 6.02% during 2001. The Manager earned a
performance-based fee in the amount of $46,000 in 2000. The Company's other
expenses increased by approximately $4,160,000 from 2000 to 2001, primarily due
the operations of the Company's mortgage banking subsidiary, expenses associated
with the Company's issuance of DERs, PSRs and restricted stock and other
corporate matters. The operations of TMHL accounted for $2,936,000 of this
increase and the Company's issuance of DERs, PSRs and restricted stock accounted
for $1,180,000 of the increase. The Company's expense ratios are among the
lowest of any company originating and investing in mortgage assets, giving the
Company what it believes to be a significant competitive advantage over more
traditional mortgage portfolio lending institutions such as banks and savings
and loans. This competitive advantage enables the Company to operate with less
risk, such as credit and interest rate risk, and still generate an attractive
long-term return on equity when compared to these more traditional mortgage
portfolio lending institutions.

The Company pays the Manager an annual base management fee, generally based on
average shareholders' equity, not assets, as defined in the Management
Agreement, payable monthly in arrears as follows: 1.18% of the first $300
million of Average Shareholders' Equity, plus 0.87% of Average Shareholders'
Equity above $300 million, subject to an annual inflation adjustment based on
changes in the Consumer Price Index. Since this management fee is based on
shareholders' equity and not assets, this fee increases as the Company
successfully accesses capital markets and raises additional equity capital and
is, therefore, managing a larger amount of invested capital on behalf of its
shareholders. In order for the Manager to earn a performance fee, the rate of
return on the shareholders' investment, as defined in the Management Agreement,
must exceed the average ten-year U.S. Treasury rate during the quarter plus 1%.
As presented in the following table, the performance fee is a variable expense
that fluctuates with the Company's return on shareholders' equity relative to
the average 10-year U.S. Treasury rate.

The following table highlights the annual trend of operating expenses as a
percent of average assets:

ANNUALIZED OPERATING EXPENSE RATIOS

RESULTS OF OPERATIONS - 2000 COMPARED TO 1999

For the year ended December 31, 2000, the Company's net income was $29,165,000,
or $1.05 per share (Diluted EPS), based on a weighted average of 21,506,000
shares outstanding. That compares to $25,584,000, or $0.88 per share (Diluted
EPS), based on a weighted average of 21,490,000 shares outstanding for the year
ended December 31, 1999. Net interest income for the year totaled $36,630,000,
compared to $34,015,000 for the same period in 1999. Net interest income is
comprised of the interest income earned on portfolio assets less interest
expense from borrowings. During 2000, the Company recorded a net gain on the
sale of ARM assets of $287,000 as compared to a net gain of $47,000 during 1999.
Additionally, during 2000, the Company reduced its earnings and the carrying
value of its ARM assets by reserving $1,158,000 for estimated credit losses,
compared to $2,867,000 during 1999. During 2000, the Company incurred operating
expenses of $6,594,000, consisting of a base management fee of $4,158,000, a
performance-based fee of $46,000 and other operating expenses of $2,390,000.
During 1999, the Company incurred operating expenses of $5,611,000, consisting
of a base management fee of $4,088,000 and other operating expenses of
$1,523,000.

The Company's return on average common equity was 6.90% for the year ended
December 31, 2000 compared to 5.81% for the year ended December 31, 1999. The
table below highlights the historical trend and the components of return on
average common equity and the 10-year U. S. Treasury average yield applicable to
the computation of the performance fee during each respective year:

39

COMPONENTS OF RETURN ON AVERAGE COMMON EQUITY(1)

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

(2) Excludes performance fees and net of loan servicing fees.

(3) Reflects implementation of FAS 133.

The following table presents the components of the Company's net interest income
for the years ended December 31, 2000 and 1999:

COMPARATIVE NET INTEREST INCOME COMPONENTS
(Dollar amounts in thousands)

As presented in the table above, the Company's net interest income was $2.6
million higher during 2000 compared to 1999. The Company's interest income was
$29.6 million higher, primarily due to higher interest rates and a lower level
of net premium amortization, in part due to slower prepayments during 2000 as
compared to 1999. The Company's amortization expense for Cap Agreements had also
declined in 2000 compared to 1999, improving interest income further. This
amortization expense declined as the Company's more expensive Cap Agreements
expired and were replaced with less expensive Cap Agreements and because a
larger proportion of the Company's ARM portfolio consisted of ARMs that did not
have lifetime caps and Hybrid ARMs that were generally match funded during their
fixed rate period, eliminating any need to hedge their lifetime cap during their
fixed rate period. The Company's interest expense increased by $27.0 million,
primarily due to higher interest rates. It is important to note that the Company
received a benefit from its use of Swaps to hedge the fixed rate period of
Hybrid ARMs, decreasing its interest expense by $4.8 million during 2000
compared to an expense of $3.5 million during 1999. The Company's use of hedges
mitigated the effect of rising short-term interest rates on the

40

financing of its Hybrid ARMs and was an important factor in the Company's
ability to increase earnings and improve return on equity in the year 2000 as
compared to 1999.

The following table reflects the average balances for each category of the
Company's interest earning assets as well as the Company's interest bearing
liabilities, with the corresponding effective rate of interest annualized for
the years ended December 31, 2000 and 1999:

AVERAGE BALANCE AND RATE TABLE
(Dollar amounts in thousands)

(1) Yield on Net Interest Earning Assets is computed by dividing annualized
net interest income by the average daily balance of interest earning
assets.

As a net result of the yield on the Company's interest-earning assets increasing
to 6.82% during 2000 from 5.92% during 1999 and the Company's cost of funds
increasing to 6.54% from 5.62%, its net interest income increased by $2,615,000.
This increase in net interest income was primarily the result of a favorable
rate variance, partially offset by a less significant unfavorable volume
variance. There was a net favorable rate variance of $2,736,000, which consisted
of a favorable variance of $39,657,000 resulting from the higher yield on the
Company's ARM assets portfolio and other interest-earning assets and an
unfavorable variance of $36,921,000 resulting from the increase in the Company's
cost of funds. The slightly lower average amount of interest earning assets
during 2000 produced an unfavorable volume variance of $10,049,000, but this was
almost entirely offset by a lower average balance of borrowings which produced a
favorable volume variance of $9,928,000, resulting in a net unfavorable volume
variance of only $122,000.

As of December 31, 2000, the Company's yield on its ARM assets portfolio,
including the impact of the amortization of premiums and discounts, the cost of
hedging, the amortization of deferred gains from hedging activity and the impact
of principal payment receivables, was 7.06%, compared to 6.38% as of December
31, 1999 -- an increase of 0.68%. The Company's cost of funds as of December 31,
2000, was 6.75%, compared to 6.47% as of December 31, 1999 -- an increase of
0.28%. As a result of these changes, the Company's net interest spread as of
December 31, 2000 was 0.31%, compared to --0.09% as of December 31, 1999 -- an
increase of 0.40%.

The Company's provision for estimated credit losses decreased to $1,158,000 in
2000 from $2,867,000 in 1999, in part, because the Company discontinued reducing
the cost basis of two securities that the Company believed had been reduced to a
cost basis that fully reflected its estimate of credit losses for these two
securities. The outlook for estimated loss on these two securities had improved
as the underlying loans had been paying off and real estate values had improved,
primarily in the California market. Additionally, during the third quarter of
2000, the Company decided to reduce its rate of providing for losses on its
whole loan credit exposure. During the Company's third quarter review of the
level of its loan loss reserves and after considering its identifiable loss
exposure to delinquent loans and the lack of any significant losses to date
recorded in the portfolio, the Company concluded that its loan loss reserves had
reached a level that it was appropriate to reduce the rate at which the Company
was recording provisions.

41

During 2000, the Company realized $287,000 in gains and no losses on the sale of
$120.0 million of ARM assets. During 1999, the Company realized a net gain from
the sale of ARM assets in the amount of $47,000.

As a REIT, the Company is required to declare dividends amounting to 85% of each
year's taxable income by the end of each calendar year and to have declared
dividends amounting to 95% (90% effective 2001) of its taxable income for each
year by the time it files its applicable tax return and, therefore, generally
passes through substantially all of its earnings to shareholders without paying
federal income tax at the corporate level. As of December 31, 2000, the Company
had met all of the dividend distribution requirements of a REIT. Since the
Company, as a REIT, pays its dividends based on taxable earnings, the dividends
may at times be more or less than reported earnings. The following table
provides a reconciliation between the Company's earnings as reported based on
generally accepted accounting principles and the Company's taxable income before
its' common dividend deduction:

RECONCILIATION OF REPORTED NET INCOME TO TAXABLE NET INCOME
(Dollar amounts in thousands)

- ----------

(1) Excludes the preferred dividend declared December 15, 2000 and paid January
10, 2001.

For the year ended December 31, 2000, the Company's ratio of operating expenses
to average assets was 0.16% compared to 0.12% for 1999. The Company's other
expenses increased by approximately $867,000, primarily due the operations of
the Company's taxable mortgage banking subsidiary, the expenses related to the
discontinued efforts to acquire a federally chartered financial institution,
expenses associated with the Company's issuance of DERs and PSRs and due to
other corporate matters.

MARKET RISKS

The market risk management discussion and the amounts estimated from the
analysis that follows are forward-looking statements regarding market risk that
assume that certain market conditions occur. Actual results may differ
materially from these projected results due to changes in the Company's ARM
portfolio and borrowings mix and due to developments in the domestic and global
financial and real estate markets. Developments in the financial markets include
the likelihood of changing interest rates and the relationship of various
interest rates and their impact on the Company's ARM portfolio yield, cost of
funds and cashflows. The analytical methods utilized by the Company to assess
and mitigate these market risks should not be considered projections of future
events or operating performance.

As a financial institution that has only invested in U.S. dollar denominated
instruments, primarily residential mortgage instruments, and has only borrowed
money in the domestic market, the Company is not subject to foreign currency
exchange or commodity price risk, but rather the Company's market risk exposure
is limited solely to interest rate risk. Interest rate risk is defined as the
sensitivity of the Company's current and future earnings to interest rate
volatility, variability of spread relationships, the difference in repricing
intervals between the Company's assets and liabilities and the effect interest
rates may have on the Company's cashflows, especially ARM portfolio prepayments.
Interest rate risk impacts the Company's interest income, interest expense and
the market value on a large portion of the Company's assets and liabilities. The

42

management of interest rate risk attempts to maximize earnings and to preserve
capital by minimizing the negative impacts of changing market rates, asset and
liability mix and prepayment activity.

The table below presents the Company's consolidated interest rate risk using the
static gap methodology. This method reports the difference between interest rate
sensitive assets and liabilities at specific points in time as of December 31,
2001, based on the earlier of term to repricing or the term to repayment of the
asset or liability. The table does not include assets and liabilities that are
not interest rate sensitive such as payment receivables, prepaid expenses,
payables and accrued expenses. The table provides a projected repricing or
maturity based on scheduled rate adjustments, scheduled payments, and estimated
prepayments. For many of the Company's assets and certain of the Company's
liabilities, the maturity date is not determinable with certainty. In general,
the Company's ARM assets can be prepaid before contractual amortization and/or
maturity. Likewise, the Company's AAA rated notes payable are paid down as the
related ARM asset collateral pays down. The static gap report reflects the
Company's investment policy that allows for only the acquisition of ARM assets
that reprice within one year, short-term fixed rate assets with an average life
of one year or less or Hybrids ARMs that are match funded to within a duration
mismatch of one-year.

The difference between assets and liabilities repricing or maturing in a given
period is one approximate measure of interest rate sensitivity. More assets than
liabilities repricing in a period (a positive gap) implies earnings will rise as
interest rates rise and decline as interest rates decline. More liabilities
repricing than assets (a negative gap) implies declining income as rates rise
and increasing income as rates decline. The static gap analysis does not take
into consideration constraints on the repricing of the interest rate of ARM
assets in a given period resulting from periodic and lifetime cap features nor
the behavior of various indexes applicable to the Company's assets and
liabilities. Different interest rate indexes exhibit different degrees of
volatility in the same interest rate environment due to other market factors
such as, but not limited to, government fiscal policies, market concern
regarding potential credit losses, changes in spread relationships among
different indexes and global market disruptions.

43

The use of interest rate instruments such as Swaps, Cap Agreements and Option
Contracts are integrated into the Company's interest rate risk management. The
notional amounts of these instruments are not reflected in the Company's balance
sheet. The Swaps that hedge the financing of the Company's Hybrid ARMs are
included in the static gap report for purposes of analyzing interest rate risk
because they have the effect of adjusting the repricing characteristics of the
Company's liabilities. The Cap Agreements and Option Contracts that hedge the
lifetime cap on the Company's ARM assets are not considered in a static gap
report because they do not effect the timing of the repricing of the instruments
they hedge, but rather they, in effect, remove the limit on the amount of
interest rate change that can occur relative to the applicable hedged asset.

INTEREST RATE SENSITIVITY GAP ANALYSIS
(Dollar amounts in millions)

December 31, 2001

Although the static gap methodology is widely accepted in identifying interest
rate risk, it does not take into consideration changes that may occur such as,
but not limited to, changes in investment and financing strategies, changes in
market spreads and relationships among different indexes, changes in asset
yields, which can change more quickly than the underlying interest coupon on ARM
assets, changes in hedging strategy, changes in prepayment speeds and changes in
business volumes. Accordingly, the Company makes extensive usage of an earnings
simulation model to analyze its level of interest rate risk. This analytical
technique used to measure and manage interest rate risk includes the impact of
all on-balance-sheet and off-balance-sheet financial instruments.

There are a number of key assumptions made in using the Company's earnings
simulation model. These key assumptions include changes in market conditions
that effect interest rates, the pricing of ARM products, the availability of ARM
products, the availability and the cost of financing for ARM products. Other key
assumptions made in using the simulation model include prepayment speeds,
management's investment, financing and hedging strategies and the issuance of
new equity. The Company typically runs the simulation model under a variety of
hypothetical business scenarios that may include different interest rate
scenarios, different investment strategies, different prepayment possibilities
and other scenarios that provide the Company with a range of possible earnings
outcomes in order to assess potential interest rate risk. The assumptions used
represent the Company's estimate of the likely effect of changes in interest
rates and do not necessarily reflect actual results.

44

The earnings simulation model takes into account periodic and lifetime caps
embedded in the Company's ARM assets in determining the earnings at risk.

At December 31, 2001, based on the earnings simulation model, the Company's
potential earnings at risk to a gradual, parallel 100 basis point rise in market
interest rates over the next twelve months was approximately 5.5% of projected
2002 net income. The assumptions used in the earnings simulation model are
inherently uncertain and as a result, the analysis cannot precisely predict the
impact of higher interest rates on net income. Actual results would differ from
simulated results due to timing, magnitude and frequency of interest rate
changes, changes in prepayment speed other than what was assumed in the model,
changes in other market conditions and management strategies to offset its
potential exposure, among other factors. This measure of risk represents the
Company's exposure to higher interest rates at a particular point in time. The
Company's actual risk is always changing. The Company continuously monitors the
Company's risk profile as it changes and alters its strategies as appropriate in
its view of the likely course of interest rates and other developments in the
Company's business.

LIQUIDITY AND CAPITAL RESOURCES

The Company's primary source of funds for the year ended December 31, 2001
consisted of reverse repurchase agreements, which totaled $4.739 billion,
collateralized notes payable, which had a balance of $432.6 million and whole
loan financing facilities, which had a balance of $37.7 million. The Company's
other significant sources of funds for the year ended December 31, 2001
consisted primarily of payments of principal and interest from its ARM assets in
the amount of $2.5 billion. In the future, the Company expects its primary
sources of funds will consist of borrowed funds under reverse repurchase
agreement transactions with one- to twelve-month maturities, funds borrowed from
whole loan financing facilities, capital market financing transactions
collateralized by ARM and hybrid loans, proceeds from monthly payments of
principal and interest on its ARM assets portfolio and occasional asset sales.
The Company's liquid assets generally consist of unpledged ARM assets, cash and
cash equivalents.

Total borrowings outstanding at December 31, 2001, had a weighted average
effective cost of 2.27%. The reverse repurchase agreements had a weighted
average remaining term to maturity of 2.8 months and the collateralized notes
payable had a final maturity of January 25, 2029, but will be paid down as the
ARM assets collateralizing the notes are paid down. The whole loan financing
facilities are committed facilities that mature in January 2002, March 2002 and
November 2002. As of December 31, 2001, $1.754 billion of the Company's
borrowings were variable-rate term reverse repurchase agreements. Term reverse
repurchase agreements are committed financings with original maturities that
range from five months to thirteen months. The interest rates on these term
reverse repurchase agreements are indexed to either the one- or three-month
LIBOR rate and reprice accordingly. The interest rate on the collateralized AAA
notes adjusts monthly based on changes in one-month LIBOR. The interest rates on
the whole loan financing facilities are indexed to the one-month LIBOR index and
are subject to either daily or monthly adjustment.

The Company has arrangements to enter into reverse repurchase agreements with 22
different financial institutions and on December 31, 2001, had borrowed funds
with 14 of these firms. Because the Company borrows money under these agreements
based on the fair value of its ARM assets and because changes in interest rates
can negatively impact the valuation of ARM assets, the Company's borrowing
ability under these agreements could be limited and lenders may initiate margin
calls in the event interest rates change or the value of the Company's ARM
assets decline for other reasons. Additionally, certain of the Company's ARM
assets are rated less than AA by the Rating Agencies (approximately 2.8%) and
have less liquidity than assets that are rated AA or higher. Other mortgage
assets which are rated AA or higher by the Rating Agencies derive their credit
rating based on a mortgage pool insurer's rating. As a result of either changes
in interest rates, credit performance of a mortgage pool or a downgrade of a
mortgage pool issuer, the Company may find it difficult to borrow against such
assets and, therefore, may be required to sell certain mortgage assets in order
to maintain liquidity. If required, these sales could be at prices lower than
the carrying value of the assets, which would result in losses. The Company had
adequate liquidity throughout the year ended December 31, 2001. Company believes
it will continue to have sufficient liquidity to meet its future cash
requirements from its primary sources of funds for the foreseeable future
without needing to sell assets.

As of December 31, 2001, the Company had $432.6 million of AAA collateralized
notes outstanding, which are not subject to margin calls. Due to the structure
of the collateralized notes, their financing is not based on market value or
subject to subsequent changes in mortgage credit markets, as is the case of the
reverse repurchase agreement arrangements.

45

As of December 31, 2001, the Company had entered into four whole loan financing
facilities. One of the whole loan financing facilities had a committed borrowing
capacity of $150 million and matured in January 2002. The Company has a second
committed whole loan financing facility that has a borrowing capacity of $300
million and matures in March 2002. The Company expects to renew this facility.
The Company also has two other whole loan financing facilities, both of which
have borrowing capacities of $150 million and mature in November 2002. The
borrowing capacity of each of these facilities can be increased, at the
Company's option, to $300 million for an additional fee. As of December 31,
2001, the Company had $37.7 million borrowed against these whole loan financing
facilities at an effective cost of 2.53%.

On May 31, 2001, the Company filed a combined shelf registration statement on
Form S-3 for $409 million of equity securities, which included $109 million of
securities that were registered under a previously filed registration statement.
On July 6, 2001, the combined registration statement for $409 million, which
includes the possible issuances of common stock, preferred stock or warrants,
was declared effective by the Securities and Exchange Commission. During August
2001, the Company completed a public offering of 5,791,500 shares of its common
stock, for which it received net proceeds of $86.9 million. During November
2001, the Company completed a second public offering of 4,340,000 shares of its
common stock, for which it received net proceeds of $66.1 million. As of
December 31, 2001, $246.5 million of the Company's securities remained
registered for future issuance and sale under its currently effective
registration statement.

The Company has a Dividend Reinvestment and Stock Purchase Plan (the "DRP")
designed to provide a convenient and economical way for existing shareholders to
automatically reinvest their dividends in additional shares of common stock and
for new and existing shareholders to purchase shares at a discount to the
current market price of the common stock, as defined in the DRP. As a result of
participation in the DRP during 2001, the Company issued 1,173,685 new shares of
common stock and received $20.7 million of new equity capital.

EFFECTS OF INTEREST RATE CHANGES

Changes in interest rates impact the Company's earnings in various ways. While
the Company only invests in ARM assets, rising short-term interest rates may
temporarily negatively affect the Company's earnings and conversely falling
short-term interest rates may temporarily increase the Company's earnings. This
impact can occur for several reasons and may be mitigated by portfolio
prepayment activity as discussed below. First, the Company's borrowings will
react to changes in interest rates sooner than the Company's ARM assets because
the weighted average next repricing date of the borrowings is usually a shorter
time period. Second, interest rates on ARM loans are generally limited to an
increase of either 1% or 2% per adjustment period (commonly referred to as the
periodic cap) and the Company's borrowings do not have similar limitations.
Third, the Company's ARM assets lag changes in the indices due to the notice
period provided to ARM borrowers when the interest rates on their loans are
scheduled to change. The periodic cap only affects the Company's earnings when
interest rates move by more than 1% per six-month period or 2% per year.

Interest rates can also affect the Company's net return on its Hybrid ARMs (net
of the cost of financing Hybrid ARMs). The Company estimates the duration of the
fixed rate period of its Hybrid ARM and has a policy to hedge the financing of
the Hybrid ARMs such that the duration difference is less than one year. The
financing of the unhedged fixed rate remaining period of one year or less is
subject to prevailing interest rates on the remaining balance of the Hybrid ARMs
at the expiration of the hedged period. As a result, if the cost of funds on
borrowings is higher at the expiration of the hedged period, the Company's net
interest spread on the remaining balance of a Hybrid ARM asset will be affected
unfavorably and conversely, if the cost of funds on borrowings is lower, the net
interest spread will be affected favorably.

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

46

The rate of prepayment on the Company's mortgage assets may increase if interest
rates decline, or if the difference between long-term and short-term interest
rates diminishes. Increased prepayments would cause the Company to amortize the
premiums paid for its mortgage assets faster, resulting in a reduced yield on
its mortgage assets. Additionally, to the extent proceeds of prepayments cannot
be reinvested at a rate of interest at least equal to the rate previously earned
on such mortgage assets, the Company's earnings may be adversely affected.

Conversely, the rate of prepayment on the Company's mortgage assets may decrease
if interest rates rise, or if the difference between long-term and short-term
interest rates increases. Decreased prepayments would cause the Company to
amortize the premiums paid for its ARM assets over a longer time period,
resulting in an increased yield on its mortgage assets. Therefore, in rising
interest rate environments where prepayments are declining, not only would the
interest rate on the ARM assets portfolio increase to re-establish a spread over
the higher interest rates, but the yield also would rise due to slower
prepayments. The combined effect could significantly mitigate other negative
effects that rising short-term interest rates might have on earnings.

Lastly, because the Company only invests in ARM assets and approximately 8% to
10% of such mortgage assets are purchased with shareholders' equity, the
Company's earnings, over time, will tend to increase, after an initial
short-term decline, following periods when short-term interest rates have risen,
and decrease after an initial short-term increase, following periods when
short-term interest rates have declined. This is because the financed portion of
the Company's portfolio of ARM assets will, over time, reprice to a spread over
the Company's cost of funds, while the portion of the Company's portfolio of ARM
assets that are purchased with shareholders' equity will generally have a higher
yield in a higher interest rate environment and a lower yield in a lower
interest rate environment.

OTHER MATTERS

The Company calculates its Qualified REIT Assets, as defined in the Internal
Revenue Code of 1986, as amended (the "Code"), to be 97.8% of its total assets,
compared to the Code requirement that at least 75% of its total assets must be
Qualified REIT Assets. The Company also calculates that 98.6% of its 2001
revenue qualifies for the 75% source of income test and 100% of its 2001 revenue
qualifies for the 95% source of income test under the REIT rules. The Company
also met all REIT requirements regarding the ownership of its common stock and
the distributions of its net income. Therefore, as of December 31, 2001, the
Company believes that it will continue to qualify as a REIT under the provisions
of the Code.

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. If
the Company were to become regulated as an investment company, the Company's use
of leverage would be substantially reduced. The Investment Company Act exempts
entities that are "primarily engaged in the business of purchasing or otherwise
acquiring mortgages and other liens on and interests in real estate"
("Qualifying Interests"). Under current interpretation of the staff of the SEC,
in order to qualify for this exemption, 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. As of December 31,
2001, the Company calculates that it is in compliance with this requirement.

47

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The information called for by Item 7A is incorporated by reference from
the information in Item 7 under the caption "Market Risk" set forth on
pages 42 through 45 in this Form 10-K.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The financial statements of the Company, the related notes and schedule
to the financial statements, together with the Report of Independent
Accountants thereon are set forth on pages F-3 through F-26 in this
Form 10-K.

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

None

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The information required by Item 10 is incorporated herein by reference
to the definitive Proxy Statement dated March 27, 2002 pursuant to
General Instruction G(3).

ITEM 11. EXECUTIVE COMPENSATION

The information required by Item 11 is incorporated herein by reference
to the definitive Proxy Statement dated March 27, 2002 pursuant to
General Instruction G(3).

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The information required by Item 12 is incorporated herein by reference
to the definitive Proxy Statement dated March 27, 2002 pursuant to
General Instruction G(3).

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

The information required by Item 13 is incorporated herein by reference
to the definitive Proxy Statement dated March 27, 2002 pursuant to
General Instruction G(3).

48

PART IV

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

(a) Documents filed as part of this report:

1. The following Financial Statements of the Company are
included in Part II, Item 8 of this Annual Report on
Form-K:

Report of Independent Accountants;
Consolidated Balance Sheets as of December 31, 2001
and 2000;
Consolidated Income Statements for the years ended
December 31, 2001, 2000 and 1999;
Consolidated Statements of Shareholders' Equity for
the years ended December 31, 2001, 2000 and 1999;
Consolidated Statements of Cash Flows for the years
ended December 31, 2001, 2000 and 1999 and Notes to
Consolidated Financial Statements.

2. Schedules to Consolidated Financial Statements:

All consolidated financial statement schedules are
included in Part II, Item 8 of this Annual Report on
Form-K.

3. Exhibits:

See "Exhibit Index".

(b) Reports on Form 8-K

The Company filed the following Current Reports on Form 8-K
during the quarter ended December 31, 2001:

(i) Current Report on Form 8-K, dated October 30, 2001
regarding (1) the Registrant's Press Release dated
October 22, 2001 announcing the Registrant's second
quarter earnings, (2) an amendment to the Amended and
Restated By-laws of the Company regarding the maximum
number of directors authorized, (3) the appointment
of Richard P. Story as an additional Director and (4)
the appointment of certain other officers.

(ii) Current Report on Form 8-K, dated November 16, 2001
regarding the Registrant's public offering of
4,000,000 shares and related underwriting agreement.

49

THORNBURG MORTGAGE, INC
AND SUBSIDIARIES

CONSOLIDATED FINANCIAL STATEMENTS

AND

REPORT OF INDEPENDENT ACCOUNTANTS

For Inclusion in Form 10-K

Filed with

Securities and Exchange Commission

December 31, 2001

THORNBURG MORTGAGE, INC
AND SUBSIDIARIES

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

F-2

REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Directors and Shareholders
Thornburg Mortgage, Inc.

In our opinion, the accompanying consolidated balance sheets and the related
consolidated income statements, shareholders' equity and cash flows present
fairly, in all material respects, the financial position of Thornburg Mortgage,
Inc. and its subsidiaries (the Company) at December 31, 2001 and 2000, and the
results of their operations and their cash flows for each of the three years in
the period ended December 31, 2001 in conformity with accounting principles
generally accepted in the United States of America. In addition, in our opinion,
the accompanying financial statement schedule presents fairly, in all material
respects, the information set forth therein when read in conjunction with the
related consolidated financial statements. These financial statements and the
financial statement schedule are the responsibility of the Company's management;
our responsibility is to express an opinion on these financial and the financial
statement schedule based on our audits. We conducted our audits of these
statements in accordance with auditing standards generally accepted in the
United States of America, which require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements, assessing
the accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.

As described in Note 1, on January 1, 2001 the Company changed its accounting
for derivative instruments.

/s/ PricewaterhouseCoopers LLP

Dallas, Texas
January 25, 2002, except for Note 9,
as to which the date is February 12, 2002

F-3

THORNBURG MORTGAGE, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS
(Amounts in thousands)

See Notes to Consolidated Financial Statements.

F-4

THORNBURG MORTGAGE, INC. AND SUBSIDIARIES

CONSOLIDATED INCOME STATEMENTS
(Amounts in thousands, except per share data)

See Notes to Consolidated Financial Statements.

F-5

THORNBURG MORTGAGE, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
Three Years Ended December 31, 2001
(Dollar amounts in thousands, except per share data)

See Notes to Consolidated Financial Statements.

F-6

THORNBURG MORTGAGE, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollar amounts in thousands)

See Notes to Consolidated Financial Statements.

F-7

THORNBURG MORTGAGE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES

Thornburg Mortgage, Inc. was incorporated in Maryland on July 28, 1992.
The Company commenced its operations of purchasing and managing for
investment a portfolio of adjustable-rate mortgage assets on June 25,
1993, upon receipt of the net proceeds from the initial public offering
of the Company's common stock.

Thornburg Mortgage, Inc. is a mortgage origination and acquisition
company that originates, acquires and invests in adjustable-rate
mortgage ("ARM") assets comprised of ARM securities and ARM loans,
thereby providing capital to the single-family residential housing
market. The Company uses its equity capital and borrowed funds to
invest 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 Company has a wholly owned mortgage banking subsidiary, TMHL, to
conduct the Company's mortgage loan acquisition and mortgage loan
origination activities. TMHL acquires mortgage loans through three
channels: bulk acquisitions, correspondent lending and retail
originations. TMHL finances the loans through four warehouse borrowing
arrangements, pools loans for securitization and sale to its parent,
and occasionally sells loans to third parties.

A summary of the Company's significant accounting policies follows:

BASIS OF PRESENTATION AND PRINCIPLES OF CONSOLIDATION

The consolidated financial statements include the accounts of
Thornburg Mortgage, Inc (together with its subsidiaries referred to
hereafter as the "Company") and its wholly-owned bankruptcy remote
special purpose finance subsidiaries, Thornburg Mortgage Funding
Corporation ("TMFC"), Thornburg Mortgage Acceptance Corporation
("TMAC") and a mortgage banking subsidiary, Thornburg Mortgage Home
Loans, Inc. ("TMHL") and its wholly-owned special purpose finance
subsidiaries, Thornburg Mortgage Funding Corporation II, Thornburg
Mortgage Acceptance Corporation II. TMFC and TMAC are wholly owned
qualified REIT subsidiaries and are consolidated with the Company
for financial statement and tax reporting purposes. During 2001,
TMHL and its subsidiaries have operated as taxable REIT subsidiaries
and are consolidated with the Company for financial statement
purposes and are not consolidated with the Company for tax reporting
purposes. Beginning on January 1, 2002, TMHL and its current
subsidiaries began operating as wholly owned qualified REIT
subsidiaries and will be consolidated with the Company for financial
statement and tax reporting purposes. All material intercompany
accounts and transactions are eliminated in consolidation.

CASH AND CASH EQUIVALENTS

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

ADJUSTABLE-RATE MORTGAGE ASSETS

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

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

The Company securitizes loans for its ARM securities portfolio. The
Company does not sell any of the securities created from this
securitization process, but rather retains all of the beneficial and
economic interests of the loans. The securitizations of the
Company's loans are not accounted for as sales and the

F-8

Company does not record any servicing assets or liabilities as a
result of this process. The fair value reflected in the Company's
financial statements for these securities is generally based on
market prices provided by certain dealers who make markets in these
financial instruments.

In general, ARM assets have a maximum lifetime interest rate cap, or
ceiling, meaning that individual ARM assets contain a contractual
maximum interest rate ("Life Cap"). ARM securities typically have a
Life Cap that not only places a constraint on the ability of an ARM
security to adjust to higher interest rates but also affects the
changes in fair value of an ARM security. As of January 1, 2001, in
connection with the Company's adoption of FAS 133, the Company
hedged the fair value changes of the Life Cap component of a portion
of its ARM portfolio. As a result, the change in fair value
associated with the Life Cap component of an ARM security in the
portfolio was recorded in earnings, subject to meeting tests of
hedging effectiveness, as well as an offsetting change in fair value
of the hedging instruments. To the extent the change in fair value
of the Life Cap component of the hedged ARM securities and the
change in fair value of the hedging instruments do not offset each
other, there is hedge ineffectiveness that is recorded in earnings.
Hedge ineffectiveness is reported in the Company's Statements of
Operations as Hedging expense. During the quarter ended September
30, 2001, the Company determined that it was impractical to continue
measuring the effectiveness of this hedge and began recording the
fair value change of these hedging instruments in the Company's
Statements of Operations as Hedging expense.

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

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

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

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

CREDIT RISK

The Company limits its exposure to credit losses on its portfolio of
ARM securities by only purchasing ARM securities that have an
investment grade rating at the time of purchase and have some form
of credit enhancement or are guaranteed by an agency of the federal
government. An investment grade security generally has a security
rating of BBB or Baa or better by at least one of two nationally
recognized rating agencies, Standard & Poor's, Inc. or Moody's
Investor Services, Inc. (the "Rating Agencies"). Additionally, the
Company also purchases and originates ARM loans and limits its
exposure to credit losses by restricting its whole loan purchases
and originations to ARM loans generally originated to "A" quality
underwriting standards or, in the case of purchased whole loans, to
loans that have at least five years of pay history and/or low loan
to property value ratios. The Company further limits its exposure to
credit risk by limiting its investment in investment grade
securities that are rated A, or equivalent, BBB, or equivalent, or
ARM loans originated to "A" quality underwriting standards ("Other
Investments") to no more than 30% of the portfolio, including the
subordinate classes of securities retained as part of the Company's
securitization of loans.

The Company, in general, securitizes all of its loans and retains
the resulting securities in its ARM portfolio. At the time of
securitization, the Company obtains a credit review by one or more
Rating Agency of the loans being securitized. Based on this review,
a determination is made regarding the expected losses to be realized
in the future and the Company adjusts the basis of the securities to
their expected realizable value. In doing so, the Company
establishes a basis adjustment amount to absorb the expected credit
losses. The Company then monitors the delinquencies and losses on
the underlying mortgage loans backing its ARM securities. If the
credit performance of the underlying mortgage loans is not as
expected, the Company

F-9

makes a provision for additional probable credit losses at a level
deemed appropriate by management to provide for known losses as well
as estimated losses inherent in its ARM securities portfolio. The
provision is based on management's assessment of numerous factors
affecting its portfolio of ARM assets including, but not limited to,
current economic conditions, delinquency status, credit losses to
date on underlying mortgages and remaining credit protection. The
provision for ARM securities is made by reducing the cost basis of
the individual security for the decline in fair value, which is
other than temporary, and the amount of such write-down is recorded
as a realized loss, thereby reducing earnings. Additionally, once a
loan within a security is 90 days or more delinquent or a borrower
declares bankruptcy, the Company adjusts the value of its accrued
interest receivable to what it believes to be collectible and stops
accruing interest on that portion of the security collateralized by
the loan.

Prior to November 2001, the Company also made a monthly provision
for estimated credit losses on its portfolio of ARM loans, which is
an increase to the allowance for loan losses. In November 2001, the
Company made the determination that virtually all of its loans were
expected to be securitized and that none of its loans were expected
to experience a loss prior to securitization. The Company completed
two loan securitization transactions in November and December 2001
and transferred the allowance for loan losses associated with the
securitized loans to the cost basis of the resulting securities. The
Company will continue to evaluate its estimated credit losses on
loans that are not expected to be securitized and for estimated
credit losses that become probable prior to securitization. The
provision for estimated credit losses on loans is based on loss
statistics of the real estate industry for similar loans, taking
into consideration factors including, but not limited to,
underwriting characteristics, seasoning, geographic location and
current economic conditions. When a loan or a portion of a loan is
deemed to be uncollectible, the portion deemed to be uncollectible
is charged against the allowance and subsequent recoveries, if any,
are credited to the allowance. Additionally, once a loan is 90 days
or more delinquent or a borrower declares bankruptcy, the Company
adjusts the value of the accrued interest receivable to what it
believes to be collectible and stops accruing interest on the loan.

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

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

VALUATION METHODS

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

DERIVATIVE FINANCIAL INSTRUMENTS

Effective January 1, 2001, the Company adopted Financial Accounting
Standard 133 ("FAS 133"), Accounting for Derivative Instruments and
Hedging Activities, as amended and interpreted. FAS 133

F-10

established accounting and reporting standards for derivative
instruments and hedging activities, including derivatives embedded
in other instruments. In accordance with FAS 133, all derivatives
are carried on the balance sheet at their fair value. If a
derivative is designated as a "fair value hedge", the changes in the
fair value of the derivative instrument and the changes in the fair
value of the hedged item are both recognized in earnings. If a
derivative is designated as a "cash flow hedge" the effective amount
of change in the fair value of the derivative instrument is recorded
in Other comprehensive income and is transferred from Other
comprehensive income to earnings as the hedged item affects
earnings. The ineffective amount of all hedges is recognized in
earnings each quarter.

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

INTEREST RATE CAP AGREEMENTS

The Company purchases interest rate cap agreements and options on
interest rate futures (collectively referred to as "Cap Agreements")
to manage interest rate risk. In general, ARM assets have a Life
Cap, which is a component of the fair value of an ARM asset. The Cap
Agreements the Company has purchased have the effect of offsetting a
portion of the fair value change in the Company's ARM assets related
to the Life Cap, and they also have the effect of allowing the yield
on the Company's ARM assets to continue to rise above their
contractual maximum rates. Pursuant to the terms of the Cap
Agreements, the Company will receive cash payments if the interest
rate index specified in any such Cap Agreement increases above
certain specified levels. Therefore, such Cap Agreements have the
effect of offsetting a portion of the Company's borrowing costs,
thereby reducing the effect of the lifetime cap feature on the
Company's ARM assets so that the yield on the Company's ARM assets
will continue to rise in high interest rate environments as the
Company's cost of borrowing rises.

All Cap Agreements were designated as fair value hedges against the
value of the Life Cap components of available-for-sale ARM
securities upon the adoption of FAS 133. In accordance with the
adoption of FAS 133, and subject to meeting certain hedging
requirements, the change in the fair value of the Cap Agreements is
recognized in earnings and is compared to the change in the fair
value of the related hedged asset to ensure the hedging relationship
is highly effective. The change in fair value associated with the
Life Cap component of the hedged portion of the ARM securities
portfolio is also recorded in earnings, subject to meeting certain
tests of hedging effectiveness. To the extent the change in fair
value of the Life Cap component of the hedged ARM securities and the
change in fair value of the hedging instruments do not offset each
other, there is hedge ineffectiveness, which is reported in the
Company's Statements of Operations as Hedging expense. The Company
determined that this hedge utilizing Cap Agreements was not
effective during the third quarter or fourth quarter of 2001 and, as
a result, the Company recorded the change in fair value of the Cap
Agreements as hedging expense with no offsetting amount associated
with the change in fair value of the hedged assets. The Company
purchases Cap Agreements by incurring a one-time fee or premium and
carries them at fair value. The carrying value of the Cap Agreements
is included in ARM securities on the balance sheet.

Upon the adoption of FAS 133, the Company recorded a cumulative
adjustment for a change in accounting principles in the amount of
$0.2 million, which reduced net income. This amount is primarily the
unrealized loss on certain Cap Agreements that had previously been
designated as hedging the Company's borrowing cost during the fixed
rate period of certain Hybrid ARMs. The Company recorded this
unrealized loss in earnings because there was no change in the
intrinsic value of the Cap Agreements since the inception of the
hedge to the date of adopting FAS 133. The Company re-designated
these Cap Agreements as fair value hedges that hedge the value of
the Life Cap component of its ARM assets consistent with the rest of
the Company's portfolio of Cap Agreements.

In addition, prior to the adoption of FAS 133, the Company had
designated the remainder of its Cap Agreements and all of its Option
Contracts as a hedge against available for sale securities and ARM
loans and had recorded the unrealized gains and losses on the Cap
Agreements, Option Contracts and available for sale securities in
Other comprehensive income. Upon the adoption of FAS 133, the
Company designated its Cap Agreements and Option Contracts as fair
value hedges against the Life Cap component

F-11

of its ARM securities. As of the FAS 133 transition date, the fair
value of the Life Cap component of its ARM securities was determined
to be $1.315 million and the Cap Agreements and Option Contracts had
a fair value of $1.319 million. Therefore, the transition adjustment
to record the reclassification of the fair value of the Cap
Agreements and Option Contracts from Other comprehensive income to
earnings and the offsetting reclassification of the fair value of
the Life Cap component of available for sale ARM securities, also
from Other comprehensive income to earnings, resulted in no material
net effect on either earnings or Other comprehensive income.

INTEREST RATE SWAP AGREEMENTS

The Company enters into interest rate swap agreements ("Swap
Agreements") in order to manage its interest rate exposure when
financing its ARM assets. The Company generally borrows money based
on short-term interest rates, either by entering into borrowings
with maturity terms of less than six months, and frequently one
month, or by entering into borrowings with longer maturity terms of
one to two years that reprice based on a frequency that is commonly
one month, but has at times been up to six months. The Company's ARM
assets generally have an interest rate that reprices based on
frequency terms of one to twelve months. The Company's Hybrid ARMs
generally have an initial fixed interest rate period of three to ten
years. As a result, the Company's existing and forecasted borrowings
reprice to a new rate on a more frequent basis than do the Company's
ARM assets. When the Company enters into a Swap Agreement, it agrees
to pay a fixed rate of interest and to receive a variable interest
rate, generally based on LIBOR. These Swap Agreements have the
effect of converting the Company's variable-rate debt into
fixed-rate debt over the life of the Swap Agreements. Swap
Agreements are used as a cost effective way to lengthen the average
repricing period of its variable rate and short-term borrowings such
that the average repricing of the borrowings more closely matches
the average repricing of the Company's ARM assets. Additionally, as
the Company acquires Hybrid ARMs, it also enters into Swap
Agreements in order to manage the interest rate repricing mismatch
between the fixed-rate period of the Hybrid ARMs and the fixed-rate
period of the Swap Agreements to a duration difference of no more
than one year. Duration measures market price volatility of
financial instruments as their balances and interest rates change
over time. The Company measures the duration of its Hybrid ARMs,
fixed rate liabilities financing Hybrid ARMs and equity using
various financial models and empirical data.

All Swap Agreements are designated as cash flow hedges against the
interest rate risk associated with the Company's borrowings.
Although the terms and characteristics of the Company's Swap
Agreements and hedged borrowings are nearly identical, due to the
explicit requirements of FAS 133, the Company does not account for
these hedges under a method defined in FAS 133 as the "shortcut"
method, but rather the Company calculates the effectiveness of this
hedge on an ongoing basis. As a result of the calculated
effectiveness of approximately 100% to date, all changes in the
unrealized gains and losses on Swap Agreements have been recorded in
Other comprehensive income and are reclassified to earnings as
interest expense is recognized on the Company's hedged borrowings.
If it becomes probable that the forecasted transaction will not
occur by the end of the originally specified time period, as
documented at the inception of the hedging relationship, or within
an additional two-month time period thereafter, then the related
gain or loss in Other comprehensive income would be reclassified to
income. For a similar reason, if the Company called its
Collateralized notes payable prior to the maturity of the Swap
Agreements designated as a cash flow hedge of a portion of that
debt, then the related gain or loss in Other comprehensive income
would be reclassified to income. As of December 31, 2001, the net
unrealized losses on Swap Agreements and deferred gains from
terminated Swap Agreements recorded in Other comprehensive income
was a net loss of $30.9 million. The Company estimates that over the
next twelve months, approximately $17.8 million of the net
unrealized losses on its Swap Agreements and the deferred gains from
terminated Swap Agreements will be reclassified from Other
comprehensive income to earnings. The carrying value of the Swap
Agreements, in the amount of $33.9 million as of December 31, 2001,
is included in Reverse repurchase agreements in the accompanying
balance sheets.

As of January 1, 2001, with the adoption of FAS 133, the Company
recorded a cumulative adjustment for a change in accounting
principle in Other comprehensive income in the net amount of $2.3
million to record the unrealized loss on its Swap Agreements, which
had previously been recorded off balance sheet. This amount was
comprised of an unrealized loss on Swap Agreements of $7.6 million
and a deferred gain from terminated Swap Agreement activity in the
amount of $5.3 million.

The Company has terminated and replaced Swap Agreements as an
additional source of liquidity when it was able to do so while
maintaining compliance with its hedging policies. Since the
Company's adoption of

F-12

FAS 133, realized gains and losses resulting from the termination of
swap agreements, are initially recorded in Other comprehensive
income as a separate component of equity. The gain or loss from the
terminated swaps remains in Other comprehensive income until the
forecasted interest payments affect earnings. If it becomes probable
that the forecasted interest payments will not occur then the entire
gain or loss would be reclassified to earnings.

OTHER HEDGING ACTIVITY

Prior to March 31, 2000, the Company entered into hedging
transactions in connection with the purchase of Hybrid ARMs between
the trade date and the settlement date. Generally, the Company has
hedged the cost of obtaining future fixed rate financing by entering
into a commitment to sell similar duration fixed-rate
mortgage-backed securities ("MBS") on the trade date and settled the
commitment by purchasing the same fixed-rate MBS on the purchase
date. Realized gains and losses were deferred and amortized as a
yield adjustment over the fixed rate period of the financing. Upon
the adoption of FAS 133, the Company recorded a cumulative
adjustment for a change in accounting principle in Other
comprehensive income in the amount of $1.7 million to record the
deferred gains from Other hedging activity, previously included in
Reverse repurchase agreements in the Company's consolidated balance
sheets. As of December 31, 2001, $0.8 million of deferred gains from
other hedging activity remained in Other comprehensive income and
the Company estimates that over the next twelve months, $0.7 million
will be reclassified to earnings.

INCOME TAXES

The Company, excluding TMHL and its subsidiaries, elected to be
taxed as a Real Estate Investment Trust ("REIT") and believes it
complies with the provisions of the Internal Revenue Code of 1986,
as amended (the "Code") with respect thereto. Accordingly, the
Company will not be subject to Federal income tax on that portion of
its income that is distributed to shareholders and as long as
certain asset, income and stock ownership tests are met. During
2001, TMHL and each of its subsidiaries were taxable REIT
subsidiaries and, as such, were subject to both federal and state
corporate income tax. For the years ended December 31, 2001 and
2000, TMHL had immaterial taxable losses. As of January 1, 2002,
the Company revoked its election to operate TMHL and its
subsidiaries as taxable REIT subsidiaries and as a result they are
now qualified REIT subsidiaries.

The Company declared a $0.55 common dividend on December 22, 2001,
which was paid on January 31, 2002. This dividend will be taken as a
dividend deduction on the Company's 2001 income tax return and is
therefore taxable income for common shareholders for 2001, as well
as the four common dividends paid during 2001.

NET EARNINGS PER SHARE

Basic EPS amounts are computed by dividing net income (adjusted for
dividends declared on preferred stock) by the weighted average
number of common shares outstanding. Diluted EPS amounts assume the
conversion, exercise or issuance of all potential common stock
instruments unless the effect is to reduce a loss or increase the
earnings per common share.

F-13

Following is information about the computation of the earnings per
share data for the years ended December 31, 2001, 2000 and 1999
(Amounts in thousands except per share data):

The Company has granted options to directors and officers of the
Company and employees of the Manager to purchase 35,666, 210,022 and
186,779 shares of common stock at average prices of $10.56, $7.43
and $8.90 per share during the years ended December 31, 2001, 2000
and 1999, respectively. As of December 31, 2001, all of the options
to purchase shares of common stock had either been exercised,
cancelled or had expired. The conversion of preferred stock was not
included in the computation of diluted EPS for any year because such
conversion would increase the diluted EPS.

RECENT ACCOUNTING PRONOUNCEMENTS

In September of 2000, the Financial Accounting Standards Board
issued SFAS No. 140, Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities. The Company has
adopted this standard effective April 1, 2001. The adoption of this
standard does not materially affect the Company's reported results
of operations or financial position. The Company has included the
required additional disclosures of SFAS 140 in Note 1 under
Adjustable-rate mortgage assets and in Note 2.

USE OF ESTIMATES

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

F-14

NOTE 2. ADJUSTABLE-RATE MORTGAGE ASSETS AND INTEREST RATE CAP AGREEMENTS

The following tables present the Company's ARM assets as of December
31, 2001 and 2000. The ARM securities classified as
available-for-sale are carried at their fair value, while the ARM
loans are carried at their amortized cost basis (dollar amounts in
thousands):

During 2001, the Company sold $108.1 million of ARM securities and
realized $244,000 in gains and $245,000 in losses. In addition, the
Company sold $0.3 million of fixed-rate loans that it originated
during 2001 for a gain of $2,000. During 2000, the Company realized
$287,000 in gains and no losses on the sale of $120.0 million of ARM
assets, and during 1999, the Company realized $52,000 in gains and
$5,000 in losses on the sale of $18.6 million of ARM assets. All of
the ARM securities sold were classified as available-for-sale.

During 2001, the Company securitized $1.219 billion of its ARM loans
into a series of privately-issued multi-class ARM securities. The
Company retained, for its ARM portfolio, all of the classes of the
securities created. In addition, during 2001, the Company swapped
$23.2 million ARM loans for FNMA guaranteed certificates. The
Company did not account for any of these securitizations as sales
and, therefore, did not record any gain or loss in connection with
these securitizations. The Company carries the securities at fair
value, based primarily on market value prices received from dealers
familiar with similar securities. As of December 31, 2001, the
Company had $1.865 billion of ARM assets that have resulted from the
Company's securitization efforts.

F-15

The Company has performed a stress test of the fair value of these
ARM assets using a discounted cash flow model that used, as its key
assumptions, prepayment speeds, potential credit losses and discount
rates. In performing the stress test, the Company made a 10% and 20%
pessimistic change to each key assumption, individually. The table
below identifies the key assumptions and the effect of each adverse
change on the fair value of the ARM assets (dollars in millions):

Carrying amount $ 1,865.0
Fair Value $ 1,866.6

Weighted average life (in years) 2.6
Prepayment speed assumption (annual rate) 29.4%
Impact on fair value of 10% adverse change $ (2.9)
Impact on fair value of 20% adverse change $ (6.7)

Projected credit losses (annual rate) 0.10%
Impact on fair value of 10% adverse change $ (0.5)
Impact on fair value of 20% adverse change $ (0.9)

Cash flow discount rate 5.49%
Impact on fair value of 10% adverse change $ (21.2)
Impact on fair value of 20% adverse change $ (41.9)

These sensitivities presented in the table above are hypothetical
and should be used with caution. As the figures indicate, changes in
fair value generally cannot be extrapolated because the relationship
of the change in assumption to the change in fair value may not be
linear. Also, in this table, the effect of a variation of a
particular key assumption is calculated without changing any other
assumption. In reality, changes in one factor may occur
simultaneously with changes in one or more of the other key
assumptions, which may magnify or offset the sensitivities.

As of December 31, 2001 and 2000, the Company had reduced the cost
basis of its securitized ARM loans by $7,925,000 and $635,000,
respectively, due to estimated credit losses (other than temporary
declines in fair value). A portion of the estimated credit losses
was provided for prior to securitization as a loan loss provision in
the amount of $3,513,000. In addition, a portion was estimated and
recorded at the time of securitization in determining the realizable
value of the subordinated classes created in the securitization
during 2001 in the amount of $3,752,000.

As of December 31, 2001 and 2000, the Company had reduced the cost
basis of other ARM securities by $1,151,000 and $1,234,000,
respectively, due to estimated credit losses (other than temporary
declines in fair value). The estimated credit losses for these ARM
securities relate to Other Investments that the Company purchased at
a discount that included an estimate of credit losses. During 2001,
the Company recorded realized losses on these ARM securities in the
amount of $83,000 and, in accordance with its credit policies, the
Company did not provided for any additional estimated credit losses.

F-16

The following tables summarize ARM loan delinquency information as
of December 31, 2001 and 2000 (dollar amounts in thousands):

2001

2000

----------
(1) ARM loans includes loans that the Company has securitized and
retained first loss credit exposure for total amounts of $1.924
billion and $1.165 billion at December 31, 2001 and 2000,
respectively.

The following table summarizes the activity for the allowance for
losses on ARM loans for the year ended December 31, 2001 and 2000
(dollar amounts in thousands):

As of December 31, 2001, the Company owned two real estate properties as
a result of foreclosing on delinquent loans in the aggregate amount of
$0.3 million. The Company believes that its current level of reserves is
adequate to cover any estimated loss, should one occur, from the sale of
these properties.

As of December 31, 2001, the Company had commitments to purchase or
originate the following amounts of ARM assets (dollar amounts in
thousands):

Agency ARM securities $ 394,146
Whole loans - correspondent 181,264
Whole loans - direct originations 157,006
-----------
$ 732,416
===========

As of December 31, 2001 and December 31, 2000, the Company had purchased
Cap Agreements with a remaining notional amount of $2.254 billion and
$2.624 billion, respectively. The notional amount of the Cap Agreements
purchased declined at a rate that is expected to approximate the
amortization of the ARM securities. Under these Cap Agreements, the
Company will receive cash payments should the one-month, three-month or
six-month London InterBank Offer Rate ("LIBOR") increase above the
contract rates of these hedging instruments that range from 5.875% to
12.00% and average approximately 10.05%. The Cap Agreements owned by the
Company, prior to the quarter ended September 30, 2001, were hedging the
fair value of the Life Cap component of the Company's ARM securities,
which have an average lifetime interest rate cap of 11.09%. During the
quarters ended September 30, 2001 and December 31, 2001, the change in
fair value of the Cap Agreements compared to the change in the fair
value of the hedged assets did not meet the effectiveness requirements
of FAS 133. Therefore, the Company recorded the change in fair value of
the Cap Agreements as hedging expense and did not record an offsetting
amount associated with the change in fair value of the hedged assets.
The Cap Agreements had an average maturity of 1.5 years as of December
31, 2001. The initial aggregate notional amount of the Cap Agreements
declines to approximately $2.173 billion over the period of

F-17

the agreements, which expire between 2002 and 2004. During the year
ended December 31, 2001, the Company recognized expenses of $1,337,000
related to hedge ineffectiveness of its fair value hedges, which is
reported as Hedging expense in the Company's Consolidated Statements of
Operations.

The Company has credit risk to the extent that the counterparties to the
Cap Agreements do not perform their obligations under the Cap
Agreements. If one of the counterparties does not perform, the Company
would not receive the cash to which it would otherwise be entitled under
the conditions of the Cap Agreement. In order to mitigate this risk and
to achieve competitive pricing, the Company has entered into Cap
Agreements with six different counterparties, five of which are rated
AAA and one is rated A, but the Company has a two-way collateral
agreement protecting its credit exposure with this counterparty. The
fair value of the Cap Agreements at December 31, 2001 amounted to
$431,000 and is included in ARM securities on the balance sheet.

NOTE 3. REVERSE REPURCHASE AGREEMENTS, COLLATERALIZED NOTES PAYABLE AND OTHER
BORROWINGS

The Company has arrangements to enter into reverse repurchase agreements
with 22 different financial institutions and on December 31, 2001, had
borrowed funds with 14 of these firms. Because the Company borrows money
under these agreements based on the fair value of its ARM assets and
because changes in interest rates can negatively impact the valuation of
ARM assets, the Company's borrowing ability under these agreements could
be limited and lenders may initiate margin calls in the event interest
rates change or the value of the Company's ARM assets decline for other
reasons.

As of December 31, 2001, the Company had outstanding $4.739 billion of
reverse repurchase agreements with a weighted average borrowing rate of
2.24% and a weighted average remaining maturity of 2.8 months. As of
December 31, 2000, the Company had outstanding $2.962 billion of reverse
repurchase agreements with a weighted average borrowing rate of 6.80%
and a weighted average remaining maturity of 2.3 months. As of December
31, 2001, $1.754 billion of the Company's borrowings were variable-rate
term reverse repurchase agreements with original maturities that range
from five months to thirteen months. The interest rates of these term
reverse repurchase agreements are indexed to either the one- or
three-month LIBOR rate and reprice accordingly. ARM assets with a
carrying value of $4.977 billion, including accrued interest,
collateralized the reverse repurchase agreements at December 31, 2001.

At December 31, 2001, the reverse repurchase agreements had the
following remaining maturities (dollar amounts in thousands):

Within 30 days $ 2,772,181
31 to 89 days 403,490
90 to 365 days 1,423,749
Over 365 days 105,475
---------------
4,704,895
Swap Agreements 33,932
---------------
$ 4,738,827
===============

As of December 31, 2001, the Company had entered into four whole loan
financing facilities. One of the whole loan financing facilities had a
committed borrowing capacity of $150 million and matured in January
2002. The Company has a second committed whole loan financing facility
that has a borrowing capacity of $300 million and matures in March 2002.
The Company expects to renew this facility. The Company also has two
other whole loan financing facilities, both of which have borrowing
capacities of $150 million and mature in November 2002. Each of these
facilities can be increased to a borrowing capacity of $300 million, at
the option of the Company, for an additional fee. As of December 31,
2001, the Company had $37.7 million borrowed against these whole loan
financing facilities at an effective cost of 2.53%. As of December 31,
2000, the Company had $158.6 million borrowed against whole loan
financing facilities at an effective cost of 7.05%. The amount borrowed
on the whole loan financing agreements at December 31, 2001 was
collateralized by ARM loans with a carrying value of $39.3 million,
including accrued interest.

The whole loan financing facility with a borrowing capacity of $300
million, discussed above, is a securitization transaction in which the
Company transfers groups of whole loans to a wholly owned bankruptcy
remote special purpose subsidiary. The subsidiary in turn simultaneously
transfers its interest in the loans to a trust, which issues beneficial
interests in the loans in the form of a note and a subordinated
certificate. The note is then used to collateralize borrowings. This
whole loan financing facility works similar to a secured line of credit
whereby

F-18

the Company can deliver loans into the facility and take loans out of
the facility at the Company's discretion, subject to the terms and
conditions of the facility. This securitization transaction is accounted
for as a secured borrowing. The Company entered into this securitization
transaction in March 2000 and began using this facility in May 2000.

On December 18, 1998, the Company, through a wholly-owned bankruptcy
remote special purpose finance subsidiary, issued $1.144 billion of
notes payable ("Notes") collateralized by ARM loans and ARM securities.
As part of this transaction, the Company retained ownership of a
subordinated certificate in the amount of $32.4 million, which
represents the Company's maximum exposure to credit losses on the loans
collateralizing the Notes. As of December 31, 2001, the Notes had a net
balance of $432.6 million, an effective interest cost of 2.65%, which
changes each month at a spread to one-month LIBOR. As of December 31,
2001, these Notes were collateralized by ARM loans with a principal
balance of $465.7 million. The Notes mature on January 25, 2029 and are
callable by the Company at par once the balance of the Notes is reduced
to 25% of their original balance. In connection with the issuance and
modification of the Notes, the Company incurred costs of approximately
$6.0 million, which is being amortized over the expected life of the
Notes. Since the Notes are paid down as the collateral pays down, the
amortization of the issuance cost will be adjusted periodically based on
actual payment experience. If the collateral pays down faster than
currently estimated, then the amortization of the issuance cost will
increase and the effective cost of the Notes will increase and,
conversely, if the collateral pays down slower than currently estimated,
then the amortization of issuance cost will be decreased and the
effective cost of the Notes will also decrease.

During September 2001, the Company entered into a $10 million line of
credit agreement collateralized by payment receivables in connection
with Agency ARM securities. As of December 31, 2001, the Company had
$2.6 million borrowed against this line of credit at an effective
interest rate of 3.93%. The interest rate on this credit line varies
with one-month LIBOR. As of December 31, 2001, this line was
collateralized by Agency ARM security payment receivables in the amount
of $3.5 million.

As of December 31, 2001, the Company was counterparty to thirty-eight
interest rate swap agreements ("Swaps") having an aggregate notional
balance of $1.690 billion. These Swaps hedge the cost of financing
Hybrid ARMs during their fixed rate term, generally three to ten years.
The Company limits the interest rate mismatch on the funding of its
Hybrid ARMs (the difference between the duration of the fixed-rate
period of Hybrid ARMs and the duration of the fixed-rate liabilities and
equity funding Hybrid ARMs) to a duration difference of no more than one
year. As of December 31, 2001, these Swaps had a weighted average
maturity of 2.8 years. 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 45 days
to 375 days. As of December 31, 2001, ARM assets with a carrying value
of $20.8 million collateralized the Swap Agreements, including accrued
interest and cash in the amount of $3.0 million.

The total cash paid for interest was $205.7 million, $249.6 million and
$233.3 million for 2001, 2000 and 1999 respectively.

NOTE 4. FAIR VALUE OF FINANCIAL INSTRUMENTS AND OFF-BALANCE SHEET CREDIT RISK

The following table presents the carrying amounts and estimated fair
values of the Company's financial instruments at December 31, 2001 and
December 31, 2000. (dollar amounts in thousands):

F-19

The above carrying amounts for assets are combined in the balance sheet
under the caption "Adjustable-rate mortgage assets." The carrying amount
for securities, which are categorized as available-for-sale, is their
fair value whereas the carrying amount for loans, which are categorized
as held for the foreseeable future, is their amortized cost.

NOTE 5. COMMON AND PREFERRED STOCK

The Company has issued 2,760,000 shares of Series A 9.68% Cumulative
Convertible Preferred Stock at a price of $25 per share. Net proceeds
from this issuance totaled $65.8 million. The dividends are cumulative
commencing on the issue date and are payable quarterly, in arrears. The
dividends per share are equal to the greater of (i) $0.605 per quarter,
or (ii) the quarterly dividend declared on the Company's common stock.
Each share is convertible at the option of the holder at any time into
one share of common stock. The preferred shares are redeemable by the
Company on and after December 31, 1999, in whole or in part, as follows:
(i) for one share of common stock plus accumulated, accrued but unpaid
dividends, provided that for 20 trading days within any period of 30
consecutive trading days the closing price of the common stock equals or
exceeds the conversion price of $25, or (ii) for cash at the issue price
of $25, plus any accumulated, accrued but unpaid dividends through the
redemption date. In the event of liquidation, the holders of the
preferred shares will be entitled to receive out of the assets of the
Company, prior to any distribution to the common shareholders, the issue
price of $25 per share in cash, plus any accumulated, accrued and unpaid
dividends. The Company has not, nor does it have any currents plans to
exercise its redemption rights at this time.

On January 25, 2001, the Board of Directors adopted a Shareholder Rights
Agreement (the "Rights Agreement"). The Board of Directors declared a
dividend distribution of one Preferred Stock Purchase Right (a "Right")
for each outstanding share of common stock, par value $0.01 per share,
of the Company (the "Common Stock") to shareholders of record as of the
close of business on April 6, 2001 (the "Record Date"). In addition, one
Right will automatically attach to each share of Common Stock issued
between the Record Date and the Distribution Date (as defined in the
Rights Agreement). Each Right entitles the registered holder thereof to
purchase from the Company a unit (a "Preferred Unit") consisting of one
one-thousandth of a share of Series B Cumulative Preferred Stock, par
value $0.01 per share (the "Preferred Stock"), at a cash exercise price
of $50.00 per Preferred Unit (the "Exercise Price"), subject to
adjustment.

The Rights have certain anti-takeover effects. The Rights will cause
substantial dilution to a person or group that attempts to acquire the
Company in a transaction not approved by the Board of Directors. The
Rights should not interfere with any merger or other business
combination approved by the Board of Directors.

On May 31, 2001, the Company filed a combined shelf registration
statement on Form S-3 for $409 million of equity securities, which
included $109 million of securities that were registered under a
previously filed registration statement. On July 6, 2001, the combined
registration statement for $409 million, which includes the possible
issuances of common stock, preferred stock or warrants, was declared
effective by the Securities and Exchange Commission. In addition, the
Company's Board of Directors suspended the Company's previously approved
program to repurchase shares. The Company had not repurchased any shares
under this program since 1998. During August 2001, the Company completed
a public offering of 5,791,500 shares of its common stock, for which it
received net proceeds of $86.9 million. Additionally, during November
2001, the Company also completed a public offering of 4,340,000 shares
of its common stock, for which it received net proceeds of $66.1
million.

During 2001, the Company issued 1,173,685 shares of common stock under
its Dividend Reinvestment and Stock Purchase Plan and received net
proceeds of $20.7 million. During 2000 and 1999, the Company did not
issue any shares of common stock under this plan.

NOTE 6. STOCK OPTION PLAN

The Company has a Stock Option and Incentive Plan (the "Plan") that
authorizes the granting of options to purchase an aggregate of up to
1,800,000 shares, but not more than 5% of the outstanding shares of the
Company's common stock. The Plan authorizes the Board of Directors, or a
committee of the Board of Directors, to grant Incentive Stock Options
("ISOs") as defined under section 422 of the Internal Revenue Code of
1986, as amended, options not so qualified ("NQSOs"), Dividend
Equivalent Rights ("DERs"), Stock Appreciation Rights ("SARs"), Phantom
Stock Rights ("PSRs") and restricted common stock.

F-20

The exercise price for any options granted under the Plan may not be
less than 100% of the fair value of the shares of the common stock at
the time the option is granted. Options become exercisable six months
after the date granted and will expire ten years after the date granted,
except options granted in connection with an offering of convertible
preferred stock, in which case such options become exercisable if and
when the convertible preferred stock is converted into common stock.

Restricted shares of common stock are granted at the discretion of the
Board of Directors and approval of the Stock Option Committee.
Restricted shares of common stock are generally granted in lieu of ISOs
and NQSOs, based on equivalent values as calculated by a Black Scholes
option model. At the time restricted shares are granted, the Board of
Directors determines the vesting period, generally three years. In
general, a portion of the restricted shares vest at the end of each year
of the vesting period and the shares participate in the common dividends
declared during the vesting period. The Company expenses the value of
the restricted shares, based on their value as of the date of grant,
over the vesting period.

The Company usually issues DERs at the same time ISOs, NQSOs and shares
of restricted stock are granted. The number of PSRs issued is based on
the level of the Company's dividends and on the price of the Company's
stock on the related dividend payment date and is equivalent to the cash
that otherwise would be paid on the outstanding DERs and previously
issued PSRs.

During 2001, there were 55,636 restricted common shares granted, 355,600
DERs granted and 45,330 PSRs issued. As of the December 31, 2001, there
were 723,574 DERs outstanding, of which 695,413 were vested, and 89,260
PSRs outstanding. The Company recorded an expense associated with the
DERs and the PSRs of $1,454,000, $274,000 and $92,000 for the years
ended December 31, 2001, 2000 and 1999, respectively. Of the expense
recorded in 2001, $700,000 was the amount of dividends paid on DERs and
PSRs, $662,000 was the impact of the increase in the Company's common
stock price on the value of the PSRs which was recorded as a fair value
adjustment and $92,000 was the amortization of the value of granting
restricted shares.

During 2001, stock options for 371,429 shares of common stock were
exercised at an average price of $8.46 and $2.7 million of notes
receivable were executed in connection with the exercise of these
options and the Company received net proceeds of $463.5 thousand. During
2000, stock options for 82,797 shares of common stock were exercised at
an average price of $8.83 and $685.7 thousand of notes receivable were
executed in connection with the exercise of these options and the
Company received net proceeds of $45.3 thousand. During 1999, there were
no exercises of stock options.

Notes receivable from stock sales result from the Company selling shares
of common stock through the exercise of stock options partially for
consideration for notes receivable. The notes mature during 2010 and
accrue interest at a rate of 3.91% per annum. In addition, the notes are
full recourse promissory notes and are secured by a pledge of the shares
of the Common Stock acquired. Interest, which is credited to
paid-in-capital, is payable quarterly, with the balance due at the
maturity of the notes. The payment of the notes will be accelerated only
upon the sale of the shares of Common Stock pledged for the notes. The
notes may be prepaid at any time at the option of each borrower. As of
December 31, 2001, there was $7.9 million of notes receivable
outstanding from stock sales.

F-21

The Company accounts for stock options under the disclosure-only
provisions of Statement of Financial Accounting Standards No. 123,
"Accounting for Stock-Based Compensation." Accordingly, no compensation
cost has been recognized for the Company's stock option plan. Had
compensation cost for the Company's stock option plan been determined
based on the fair value at the grant date for awards in 2001, 2000 and
1999 consistent with the provisions of SFAS No. 123, the Company's net
earnings and earnings per share would have been reduced to the pro forma
amounts indicated in the table below. The fair value of each stock
option grant is estimated on the date of grant using the Black-Scholes
option-pricing model (dollar amounts in thousands, except per share
data).

Information regarding stock options is as follows:

As presented in the table above, all of the stock options outstanding as
of December 31, 2000 and the ones granted during 2001 were either
cancelled or exercised during 2001. As of December 31, 2001, there are
no stock options outstanding.

In January 2001, outstanding stock options for 578,303 shares at option
exercise prices of $15.00 per share and above were voluntarily
surrendered and cancelled by the officers and directors of the Company
and employees of the Manager who held the options. The cancelled options
were returned to the Plan and are available for future option grants
under the Plan.

F-22

NOTE 7. TRANSACTIONS WITH AFFILIATES

The Company has a Management Agreement (the "Agreement") with Thornburg
Mortgage Advisory Corporation ("the Manager"). Under the terms of this
Agreement, the Manager, subject to the supervision of the Company's
Board of Directors, is responsible for the management of the day-to-day
operations of the Company and provides all personnel and office space.
According to the terms of the Agreement, certain defined expenses of the
Manager are reimbursed by the Company, principally expenses of the
Company's mortgage banking subsidiary related to mortgage loan
acquisition, selling, servicing and securitization activities. During
the years ended December 31, 2001 and 2000, TMHL reimbursed the Manager
$1,599,000 and $75,000 for expenses, respectively, in accordance with
the terms of the Agreement. The Agreement has a ten-year term and
provides for an annual review by the unaffiliated directors of the Board
of Directors of the Manager's performance under the Agreement. If the
Company terminates the Agreement for a reason other than for cause, a
minimum fee would be due to the Manager.

The Company pays the Manager an annual base management fee based on
average shareholders' equity, adjusted for liabilities that are not
incurred to finance assets ("Average Shareholders' Equity" or "Average
Net Invested Assets" as defined in the Agreement) payable monthly in
arrears as follows: 1.18% of the first $300 million of Average
Shareholders' Equity, plus 0.87% of Average Shareholders' Equity above
$300 million. The Agreement also has a cost of living clause that
adjusts the base management fee formula by the change in the Consumer
Price Index over the previous twelve-month period, effective as of each
annual review of the Agreement. In addition, the three wholly-owned
subsidiaries of the Company and the two wholly-owned subsidiaries of
TMHL have entered into separate Management Agreements with the Manager
for additional management services for a combined amount of $1,200 per
month, paid in arrears.

For the years ended December 31, 2001, 2000 and 1999, the Company
incurred costs of $4,897,000, $4,158,000 and $4,088,000, respectively,
in base management fees in accordance with the terms of the Management
Agreements. As of December 31, 2001 and 2000, $510,000 and $361,000,
respectively, was payable by the Company to the Manager for the base
management fee.

The Manager is also entitled to earn performance based compensation in
an amount equal to 20% of the Company's annualized net income, before
performance based compensation, above an annualized Return on Equity
equal to the ten year U.S. Treasury Rate plus 1%. For purposes of the
performance fee calculation, equity is generally defined as proceeds
from issuance of common stock before underwriter's discount and other
costs of issuance, plus retained earnings. For the year ended December
31, 2001 and 2000, the Company earned performance based compensation in
the amount of $6,716,000 and $46,000, respectively, in accordance with
the terms of the Agreement. As of December 31, 2001 and 2000, $3,092,000
and $46,000, respectively, was payable by the Company to the Manager for
performance based compensation. For the year ended December 31, 1999,
the Company did not pay the Manager any performance based compensation
because the Company's net income, as measured by Return on Equity, did
not exceed the ten-year U.S. Treasury Rate plus 1%.

For the years ended December 31, 2001 and 2000, the Company reimbursed
the Manager and other affiliated companies $112,000 and $95,000,
respectively, for certain other direct expenses of the Company,
primarily related to shareholder relations, public relations and
marketing consulting services. Beginning in 1999, the Company's
subsidiaries, except TMHL, entered into separate lease agreements with
the Manager for office space in Santa Fe, New Mexico. During 2001, 2000
and 1999, the combined amount of rent paid to the Manager was $14,000,
$31,000 and $10,000, respectively.

F-23

NOTE 8. SUMMARIZED QUARTERLY RESULTS (UNAUDITED)

The following is a presentation of the quarterly results of operations
(amounts in thousands, except per share amounts):

NOTE 9. SUBSEQUENT EVENT

On February 12, 2002, the Company completed a public offering of
5,400,000 shares of its common stock pursuant to its Registration
Statement on Form S-3 that was declared effective on July 6, 2001. The
Company received net proceeds of $99.1 million. In addition, the Company
has granted the underwriters a 30-day option to purchase up to an
additional 810,000 shares of common stock to cover over-allotments at
the public offering price of $19.41 per share, less the underwriting
discounts and commissions.

F-24

SCHEDULE IV - Mortgage Loans on Real Estate

Column A, Description: The Company's whole loan portfolio at December 31, 2001,
which consists of only first mortgages on single-family residential housing, is
stratified as follows (dollar amounts in thousands):

F-25

(2) The provision for losses is based on management's assessment of various
factors.

(3) Cost for Federal income taxes is the same.

(4) The geographic distribution of the Company's whole loan portfolio at
December 31, 2001 is as follows:

F-26

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Act of
1934, the Registrant has duly caused this report to be signed on its behalf by
the undersigned, thereunto duly authorized.

THORNBURG MORTGAGE, INC.
(Registrant)

Dated: March 27, 2002 /s/ Garrett Thornburg
----------------------------------------
Garrett Thornburg
Chairman of the Board of Directors and
Chief Executive Officer
(Principal Executive Officer)

Dated: March 27, 2002 /s/ Richard P. Story
----------------------------------------
Richard P. Story
Executive Vice President, Director
and Chief Financial Officer
(Principal Accounting Officer)

Pursuant to the requirements of the Securities and Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.

Exhibit Index

- --------------------------
* Being filed herewith.

(a) Previously filed with Registrant's Form 8-K dated October 10, 1995 and
incorporated herein by reference pursuant to Rule 12b-32.

(b) Previously filed as part of Form S-11 which went effective on June 18, 1993
and incorporated herein by reference pursuant to Rule 12b-32.

(c) Previously filed with Registrant's Form 10-Q dated June 30, 1995 and
incorporated herein by reference pursuant to Rule 12b-32.

(d) Previously filed as part of Form 8-A dated January 17, 1997 and
incorporated herein by reference pursuant to Rule 12b-32.

(e) Previously filed with Registrant's Form 10-Q dated March 31, 2000 and
incorporated herein by reference pursuant to Rule 12b-32.

(f) Previously filed as part of Form S-8 dated July 1, 1994 and incorporated
herein by reference pursuant to Rule 12b-32.

(g) Previously filed with Registrant's Form 10-Q dated September 30, 1999 and
incorporated herein by reference pursuant to Rule 12b-32.

(h) Previously filed with Registrant's Form 10-Q dated June 30, 1999 and
incorporated herein by reference pursuant to Rule 12b-32.

(i) Previously filed with Registrant's Form 10-Q dated September 30, 2000 and
incorporated herein by reference pursuant to Rule 12b-32.

(j) Previously filed with Registrant's Form 10-K dated December 31, 1996 and
incorporated herein by reference pursuant to Rule 12b-32.

(k) Previously filed with Registrant's Form 10-K dated December 31, 1997 and
incorporated herein by reference pursuant to Rule 12b-32.

(l) Previously filed as Exhibit 4 to Registrant's registration statement on
Form S-3D dated September 24, 1997 and incorporated herein by reference
pursuant to Rule 12b-32.

(m) Previously filed with Registrant's Form 10-K dated December 31, 1998 and
incorporated herein by reference pursuant to Rule 12b-32.

(n) Filed on March 27, 2002 and incorporated by reference pursuant to Rule
12b-32.

(o) Previously filed with Registrant's Form 10-K dated December 31, 2000 and
incorporated by reference pursuant to Rule 12b-32.

(p) Previously filed with Registrant's Form 10-Q dated September 30, 2001 and
incorporated herein by reference pursuant to Rule 12b-32.