THORNBURG MORTGAGE INC - 10-Q Quarterly Report

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

FORM 10-Q

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

FOR THE QUARTERLY PERIOD ENDED: JUNE 30, 2002

OR

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

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

COMMISSION FILE NUMBER: 001-11914

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

MARYLAND 85-0404134
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification Number)

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

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

(Former name, former address and former fiscal year,
if changed since last report)

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

(1) Yes X No
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(2) Yes X No
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APPLICABLE ONLY TO CORPORATE ISSUERS:

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

Common Stock ($.01 par value) 45,586,142 as of August 9, 2002

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THORNBURG MORTGAGE, INC.
FORM 10-Q

INDEX

2

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

THORNBURG MORTGAGE, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS
(Amounts in thousands)

See Notes to Consolidated Financial Statements.

3

THORNBURG MORTGAGE, INC. AND SUBSIDIARIES

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

See Notes to Consolidated Financial Statements.

4

THORNBURG MORTGAGE, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (UNAUDITED)

Six Months Ended June 30, 2002 and 2001

(In thousands, except share data)

See Notes to Consolidated Financial Statements.

5

THORNBURG MORTGAGE, INC. AND SUBSIDIARIES

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

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

See Notes to Consolidated Financial Statements

6

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1. SIGNIFICANT ACCOUNTING POLICIES

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

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

BASIS OF PRESENTATION AND PRINCIPLES OF CONSOLIDATION

The consolidated financial statements include the accounts of
Thornburg Mortgage, Inc. (together with its subsidiaries
referred to hereafter as the "Company") and its two
wholly-owned bankruptcy remote special purpose finance
subsidiaries, Thornburg Mortgage Funding Corporation ("TMFC")
and Thornburg Mortgage Acceptance Corporation ("TMAC"), its
wholly-owned mortgage banking subsidiary, Thornburg Mortgage
Home Loans, Inc. ("TMHL"), and TMHL's two wholly-owned special
purpose finance subsidiaries, Thornburg Mortgage Funding
Corporation II and Thornburg Mortgage Acceptance Corporation
II. 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 operated as taxable REIT subsidiaries and were
consolidated with the Company for financial statement purposes
but were not consolidated with the Company for tax reporting
purposes. Beginning on January 1, 2002, TMHL and its
subsidiaries began operating as wholly owned qualified REIT
subsidiaries and are consolidated with the Company for
financial statement and tax reporting purposes. All material
intercompany accounts and transactions are eliminated in
consolidation. Certain reclassifications have been made to
prior years' amounts to conform with current year
classifications.

CASH AND CASH EQUIVALENTS

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

ADJUSTABLE-RATE MORTGAGE ASSETS

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

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

The Company securitizes loans for its ARM securities
portfolio. The Company does not sell any of the securities
created from this securitization process, but rather retains
all of the beneficial and economic interests of the loans. The
securitizations of the Company's loans are not accounted for
as sales and the Company does not capitalize any servicing
rights or obligations as a result of this process. The fair
value reflected in the Company's financial statements for
these securities is

7

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.

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

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

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

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

CREDIT RISK

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

The Company, in general, securitizes all of its loans and
retains the resulting securities in its ARM portfolio. At the
time of securitization, the Company obtains a credit review by
one or more Rating Agencies of the loans being securitized.
Based on this review, the Company makes a determination
regarding the expected losses to be realized in the future and
adjusts the basis of the securities to their expected
realizable value. In doing so, the Company establishes a basis
adjustment amount to absorb the expected credit losses. The
Company then monitors the delinquencies and losses on the
underlying mortgage loans backing its ARM securities. If the
credit performance of the underlying mortgage loans is not as
good as expected, the Company makes a provision for additional
probable credit losses at a level deemed appropriate by
management to provide for known losses as well as estimated
losses inherent in its ARM securities portfolio. The provision
is based on management's assessment of numerous factors
affecting the Company's portfolio of ARM assets including, but
not limited to, current economic conditions, delinquency
status, credit losses to date on underlying mortgages and
remaining credit

8

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.

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 reduces
the cost basis of the subordinated security retained at the
time the collateralized notes payable are issued, to take into
consideration estimated credit losses on the underlying loans.

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

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

VALUATION METHODS

The fair values of the Company's ARM securities and interest
rate cap agreements (as defined below) are generally based on
market prices provided by certain dealers who make markets in
these financial instruments or third-party pricing services.
If the fair value of an ARM security is not reasonably
available from a dealer or a third-party pricing service,
management estimates the fair value based on characteristics
of the security that the Company receives from the issuer and
available market information. The fair values for ARM loans
are estimated by the Company by using the same pricing models
employed by the Company in the process of determining a price
to bid for loans in the open market, taking into consideration
the aggregated characteristics of groups of loans such as, but
not limited to, collateral type, index, margin, life cap,
periodic cap, underwriting standards, age and delinquency
experience. The fair value of the Company's collateralized
notes payable and interest rate swap agreements is 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

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.

9

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

INTEREST RATE CAP AGREEMENTS

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

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

INTEREST RATE SWAP AGREEMENTS

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 generally 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.

All Swap Agreements are designated as cash flow hedges against
the interest rate risk associated with the Company's
borrowings. Although the terms and characteristics of the
Company's Swap Agreements and hedged borrowings are nearly
identical, due to the explicit requirements of FAS 133, the
Company does not account for these hedges under a method
defined in FAS 133 as the "shortcut" method, but rather the
Company calculates the effectiveness of these hedges on an
ongoing basis. 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, which in this case refers to interest payments to
be made under the Company's short-term borrowing agreements,
will not occur by the end of the originally specified time
period, as documented at the inception of the hedging
relationship, or within an additional two-month time period
thereafter,

10

then the related gain or loss in "Other comprehensive income"
would be reclassified to income. As of June 30, 2002, the net
unrealized loss on Swap Agreements and deferred gains from
terminated Swap Agreements recorded in "Other comprehensive
income" was a net loss of $54.5 million. The Company estimates
that over the next twelve months, approximately $28.3 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 loss on Swap Agreements is the discounted value of the
remaining future net interest payments expected to be made
over the remaining life of the Swap Agreements. Therefore,
over time, as the actual payments are made, the unrealized
loss in "Other comprehensive income" and the carrying value of
the Swap Agreements adjusts to zero and the Company realizes a
fixed cost of money over the life of the hedging instrument.
The carrying value of the Swap Agreements, in the amount of
$55.9 million as of June 30, 2002, is included in "Reverse
repurchase agreements" in the accompanying balance sheets.

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

INCOME TAXES

The Company elected to be taxed as a Real Estate Investment
Trust ("REIT") and believes it complies with the provisions of
the Internal Revenue Code of 1986, as amended (the "Code")
with respect thereto. Accordingly, the Company will not be
subject to Federal income tax on that portion of its income
that is distributed to shareholders 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. 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.

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.

11

Following is information about the computation of the earnings
per share data for the three and six month periods ended June
30, 2002 and 2001 (amounts in thousands except per share
data):

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

USE OF ESTIMATES

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

13

NOTE 2. ADJUSTABLE-RATE MORTGAGE ASSETS

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

During the six-month period ended June 30, 2002, the Company sold
$62.7 million of ARM securities for a gain of $95,000. The ARM
securities sold were classified as available-for-sale. In
addition, the Company sold $3.7 million of loans during the first
six months of 2002 and realized a gross gain of $6,000 and a gross
loss of $14,000. During the six-month period ended June 30, 2001,
the Company sold $108.1 million of ARM securities and realized
$244,000 in gains and $245,000 in losses. In addition, the Company
sold $0.3 million of fixed-rate loans that it originated during
the first six months of 2001 for a gain of $3,000.

During the six-month period ended June 30, 2002, the Company
securitized $963.9 million of its ARM loans into a series of
privately-issued multi-class ARM securities. The Company retained,
for its ARM portfolio, all of the classes of the securities
created. The Company did not account for any of these
securitizations as sales and, therefore, did not record any gain
or loss in connection with the securitizations. As of June 30,
2002, the Company had $2.435 billion of ARM assets that have
resulted from the Company's securitization efforts.

14

As of June 30, 2002 and December 31, 2001, the Company had reduced
the cost basis of its securitized ARM loans by $10,510,000 and
$7,925,000, respectively, due to estimated credit losses (other
than temporary declines in fair value). The reduction in the cost
basis recorded during the six months of 2002, in the amount of
$2,585,000, was recorded in connection with the Company's
securitization of the $963.9 million of loans.

As of June 30, 2002 and December 31, 2001, the Company had reduced
the cost basis of other ARM securities by $1,002,000 and
$1,151,000, respectively, due to estimated credit losses (other
than temporary declines in fair value). The estimated credit
losses for these ARM securities relate to Other Investments that
the Company purchased at a discount that included an estimate of
credit losses. During the six-month period ended June 30, 2002,
the Company recorded realized losses on these ARM securities in
the amount of $293,000 and realized recoveries in the amount of
$144,000 and, in accordance with its credit policies, the Company
did not provide for any additional estimated credit losses.

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

(1) ARM loans includes loans that the Company has securitized
and retained first loss credit exposure for total amounts
of $2.730 billion and $1.924 billion at June 30, 2002 and
December 31, 2001, respectively.

As of June 30, 2002, the Company owned two real estate properties
as a result of foreclosing on delinquent loans in the aggregate
amount of $0.5 million. The Company has a $0.1 million reserve for
estimated losses on these properties. The Company believes that
its current level of reserves is adequate to cover any estimated
loss, should one occur, from the sale of these properties.

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

Agency ARM securities $ 180,458
Whole loans - correspondent 279,745
Whole loans - direct originations 58,564
-------------
$ 518,767
=============

15

During the quarter ended June 30, 2002, the Company entered into a
transaction whereby the Company expects to acquire the remaining
balance of certain Hybrid ARM securities, at a price of par, in
2006 when the fixed-rate period of the Hybrid ARM securities
terminates and they convert into ARM securities. The current
balance of the Hybrid ARM securities is approximately $1.8
billion, but is expected to be significantly less, and could be
zero, at the time they convert into ARM securities. If the Company
decides not to acquire the Hybrid ARM securities when they convert
into ARM securities, then it is committed to pay or receive the
difference between par and the fair value of the ARM securities at
that time, as determined by an auction of the ARM securities. In
order to enter into this transaction, the Company was obligated to
deliver $5.0 million of collateral. This collateral obligation
will be reduced in proportion to the declining balance of the ARM
securities expected to be purchased.

NOTE 3. INTEREST RATE CAP AGREEMENTS

Included in "Prepaid Expenses and Other" are purchased Cap
Agreements with a remaining notional amount of $2.205 billion and
$2.254 billion as of June 30, 2002 and December 31, 2001,
respectively. The notional amount of the Cap Agreements purchased
declines at a rate that is expected to approximate the
amortization of the ARM securities. Under these Cap Agreements,
the Company will receive cash payments should the one-month or
three-month London InterBank Offer Rate ("LIBOR") increase above
the contract rates of these hedging instruments which range from
6.00% to 12.00% and average approximately 9.90%. The Cap
Agreements had an average maturity of 1.3 years as of June 30,
2002. The initial aggregate notional amount of the Cap Agreements
declines to approximately $2.148 billion over the period of the
agreements, which expire between 2002 and 2005. During the three
and six-month periods ended June 30, 2002, the Company recognized
expenses of $622,000 and $936,000, respectively, which is reported
as "Hedging expense" in the Company's Consolidated Statements of
Operations.

The Company has credit risk to the extent that the counterparties
to the Cap Agreements do not perform their obligations under the
Cap Agreements. If one of the counterparties does not perform, the
Company would not receive the cash to which it would otherwise be
entitled under the conditions of the Cap Agreement. In order to
mitigate this risk and to achieve competitive pricing, the Company
has entered into Cap Agreements with six different counterparties,
five of which are rated AAA and one which is rated A, but the
Company has a two-way collateral agreement protecting its credit
exposure with this counterparty. The fair value of the Cap
Agreements at June 30, 2002 amounted to $257,000 and is included
in "Prepaid expenses and other" on the balance sheet.

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

The Company has arrangements to enter into reverse repurchase
agreements with 25 different financial institutions and on June
30, 2002, 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 June 30, 2002, the Company had outstanding $7.554 billion of
reverse repurchase agreements with a weighted average borrowing
rate of 2.02% and a weighted average remaining maturity of 3.8
months. 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 June 30, 2002, $3.400 billion of the
Company's borrowings were variable-rate term reverse repurchase
agreements with original maturities that range from three months
to eighteen months. The interest rates of these term reverse
repurchase agreements are indexed to either the one- or
three-month LIBOR rate and reprice accordingly. ARM assets with a
carrying value of $7.956 billion, including accrued interest, and
cash in the amount of $3.5 million collateralized the reverse
repurchase agreements at June 30, 2002.

16

At June 30, 2002, the reverse repurchase agreements had the
following remaining maturities (dollar amounts in thousands):

Within 30 days $ 3,786,414
31 to 89 days 822,237
90 to 365 days 2,783,817
Over 365 days 105,475
---------------
7,497,943
Swap Agreements 55,823
---------------
$ 7,553,766
===============

As of June 30, 2002, the Company had entered into three whole loan
financing facilities. Each of the whole loan financing facilities
has a committed borrowing capacity of $300 million; one matures in
March 2003 and the other two mature in November 2002. As of June
30, 2002, the Company had $280.8 million borrowed against these
whole loan financing facilities at an effective cost of 2.50%. As
of December 31, 2001, the Company had $37.7 million borrowed
against whole loan financing facilities at an effective cost of
2.53%. The amount borrowed on the whole loan financing agreements
at June 30, 2002 was collateralized by ARM loans with a carrying
value of $290.7 million, including accrued interest.

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

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 June
30, 2002, the Notes had a net balance of $316.8 million and an
effective interest cost of 2.56%, which changes each month at a
spread to one-month LIBOR. As of June 30, 2002, these Notes were
collateralized by ARM loans with a principal balance of $349.3
million. The Notes mature on January 25, 2029 and are callable by
the Company at par once the total balance of the loans
collateralizing the Notes is reduced to 25% of their original
balance.

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 June 30, 2002, the
Company was not borrowing any amount against this line. 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 June 30, 2002, the Company was a counterparty to forty-eight
Swap Agreements having an aggregate notional balance of $3.796
billion. These Swap Agreements hedge the cost of financing Hybrid
ARMs during their fixed rate term, generally three to ten years.
The Company limits the interest rate mismatch on the funding of
its Hybrid ARMs (the difference between the duration of the
fixed-rate period of Hybrid ARMs and the duration of the
fixed-rate liabilities) to a duration difference of no more than
one year. As of June 30, 2002, these Swap Agreements had a
weighted average maturity of 2.5 years. In accordance with these
Swap Agreements, the Company will pay a fixed rate of interest
during the term of these Swap Agreements and receive a payment
that varies monthly with

17

the one-month LIBOR rate. As a result of entering into these Swap
Agreements, the Company has reduced the interest rate variability
of its cost to finance its Hybrid ARM assets by increasing the
average period until the next repricing of its borrowings from 39
days to 746 days. As of June 30, 2002, ARM assets with a carrying
value of $40.5 million collateralized the Swap Agreements,
including accrued interest and cash in the amount of $4.1 million.

The total cash paid for interest was $55.0 million and $51.3
million during the quarters ended June 30, 2002 and 2001,
respectively.

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

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

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

NOTE 6. COMMON AND PREFERRED STOCK

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 February 2002, the Company completed a public
offering of 6,210,000 shares of its common stock, for which it
received net proceeds of $113.5 million. In addition, during both
the three and six-month periods ended June 30, 2002, the Company
issued 2,530,800 shares of common stock under a continuous equity
offering program and received net proceeds of $48.3 million. As of
June 30, 2002, $76.3 million of the Company's securities remained
registered for future issuance and sale under its currently
effective registration statement.

During the three and six-month periods ended June 30, 2002, the
Company issued 927,592 and 2,312,812 shares, respectively, of
common stock under its Dividend Reinvestment and Stock Purchase
Plan and received net proceeds of $18.5 and $45.8 million,
respectively.

On April 23, 2002, the Company declared the first quarter 2002
dividend of $0.55 per common share, which was paid on May 17, 2002
to common shareholders of record as of May 3, 2002.

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

18

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

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

NOTE 7. STOCK OPTION PLAN

The Company 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 is intended to be a
long-term incentive program. 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.

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 had been granted at the
discretion of the Stock Option Committee and approval of the Board
of Directors. Restricted shares of common stock have generally
been 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. In April 2002, the Company's Board of
Directors cancelled all previously granted restricted shares of
common stock and replaced them with PSRs of equal value. The
replacement PSRs vest over the original vesting period of the
cancelled restricted shares. The Stock Option Committee, with the
approval of the Board of Directors, is currently issuing PSRs in
lieu of stock options using the same methodology under which the
restricted shares of common stock were being granted.

The Company usually issues DERs at the same time ISOs, NQSOs, PSRs
or shares of restricted stock are granted. The Company also allows
its DER and PSR participants to elect to reinvest their PSR and
DER cash dividends into additional PSRs at the price of the
Company's common stock on the related dividend payment date.

As of June 30, 2002, there were 975,839 DERs outstanding, of which
947,678 were vested, and 314,094 PSRs outstanding, of which
141,548 were vested. The Company recorded an expense associated
with DERs and PSRs of $932,000 and $273,000 for the three-month
periods ended June 30, 2002 and 2001, respectively. During the
six-month periods ended June 30, 2002 and 2001, the Company
recorded an expense associated with DERs and PSRs in the amount of
$1,479,000 and $521,000, respectively. Of the expense recorded
during the second quarter of 2002, $676,000 was the amount of
dividend equivalents paid on DERs and PSRs, $12,000 was the impact
of the decrease in the Company's common stock price on the value
of the PSRs which was recorded as a fair value adjustment and
$268,000 was the amortization of unvested PSRs. Of the expense
recorded during the second quarter of 2001, $125,000 was the
amount of dividend equivalents paid on DERs and PSRs and $148,000
was the impact of the increase in the Company's common stock price
on the value of the

19

PSRs which was recorded as a fair value adjustment. As of June 30,
2002, all of the previously issued ISOs and NQSOs have been
exercised, terminated or cancelled.

Notes receivable arise from the Company financing a portion of the
purchase of shares of common stock that have been obtained by
directors and employees through the exercise of stock options. The
notes mature during 2010 and accrue interest at a rate of 3.91%
per annum. In addition, the notes are full recourse promissory
notes and are secured by a pledge of the shares of the common
stock acquired. Interest, which is credited to paid-in-capital, is
payable quarterly, with the balance due at the maturity of the
notes. The payment of the notes will be accelerated only upon the
sale of the shares of common stock pledged for the notes. The
notes may be prepaid at any time at the option of each borrower.
As of June 30, 2002, there was $7.9 million of notes receivable
outstanding from stock sales.

NOTE 8. TRANSACTIONS WITH AFFILIATES

The Company has a Management Agreement (the "Agreement") with
Thornburg Mortgage Advisory Corporation ("the Manager"). Under the
terms of the Agreement, the Manager, subject to the supervision of
the Company's Board of Directors, is responsible for the
management of the day-to-day operations of the Company and
provides 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
quarters ended June 30, 2002 and 2001, TMHL reimbursed the Manager
$943,000 and $226,000 for expenses, respectively, in accordance
with the terms of the Agreement. During the six-month periods
ended June 30, 2002 and 2001, TMHL reimbursed the Manager
$1,400,000 and $452,000 for expenses, respectively. The Agreement
has a ten-year term and provides for an annual review of the
Manager's performance under the Agreement by the unaffiliated
directors of the Board of Directors. 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 quarters ended June 30, 2002 and 2001, the Company
incurred costs of $1,902,000 and $1,116,000, respectively, in base
management fees in accordance with the terms of the Management
Agreements. For the six month periods ended June 30, 2002 and
2001, the Company incurred base management fees of $3,546,000 and
$2,211,000, respectively. As of June 30, 2002 and 2001, $647,000
and $377,000, respectively, was payable by the Company to the
Manager for the base management fee.

The Manager is also entitled to earn performance based
compensation in an amount equal to 20% of the Company's annualized
net income, before performance based compensation, above an
annualized Return on Equity equal to the ten year U.S. Treasury
Rate plus 1%. For purposes of the performance fee calculation,
equity is generally defined as proceeds from issuance of common
stock before underwriter's discount and other costs of issuance,
plus retained earnings. For the three- and six-month periods ended
June 30, 2002, the Manager earned performance based compensation
in the amount of $3,721,000 and $6,914,000, respectively, in
accordance with the terms of the Agreement. For the three- and
six-month periods ended June 30, 2001, the Manager earned
performance based compensation in the amount of $1,073,000 and
$1,997,000, respectively.

20

During the three- and six-month periods ended June 30, 2002, the
Company reimbursed the Manager and other affiliated companies
$23,000 and $97,000, respectively, for certain other direct
expenses of the Company, primarily related to shareholder
relations, public relations and marketing consulting services.
During the three- and six-month periods ended June 30, 2001, the
Company reimbursed the Manager and other affiliated companies
$36,000 and $44,000, respectively, for such expenses. The
Company's subsidiaries, except TMHL, have entered into separate
lease agreements with the Manager for office space in Santa Fe,
New Mexico. During the quarters ended June 30, 2002 and 2001, the
combined amount of rent paid to the Manager was $4,000 and $3,000,
respectively. During the six-month periods ended June 30, 2002 and
2001, the combined amount of rent paid to the Manager was $7,000
and $7,000, respectively.

Pursuant to an employee residential mortgage loan program approved
by the Board of Directors, certain of the Company's directors and
officers have obtained residential first lien mortgage loans from
the Company. In general, the terms of the loans and the
underwriting requirements are identical to the loan programs that
the Company offers to unaffiliated third parties, except that
participants in the program qualify for an employee discount on
the interest rate. At the time each participant enters into a loan
agreement, such participant executes an addendum that provides for
the discount on the interest rate which is subject to cancellation
at the time such participant's employment with the Company is
terminated for any reason. Effective with the passage of U.S.
congressional legislation in July of 2002, any new loans made to
directors or executive officers will not be eligible for the
employee discount. As of June 30, 2002, the aggregate balance of
mortgage loans outstanding to directors and officers of the
Company and employees of the Manager amounted to $5.0 million, had
a weighted average interest rate of 4.95% and mature between 2016
and 2032.

21

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

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

MANAGEMENT'S DISCUSSION OF CORPORATE GOVERNANCE

In light of recent publicity regarding Corporate Governance and recent
incidences involving the accounting practices of certain public companies, we
would like to point out a number of ways we conduct our business that
differentiate us from such companies.

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

Second, our Chief Executive Officer, President and Chief Financial Officer have
been involved in assuring the accuracy and completeness of all financial
statements, and are more than willing to certify the accuracy of the financial
information in each annual and quarterly report that we have issued and we are
certifying the accuracy of this quarterly report. Further, under our internal
information gathering procedures, we consult with appropriate key personnel
throughout our organization to assure the accuracy and completeness of our
disclosures, description of our operations and policies and other financial
information included in our annual and quarterly reports.

Finally, all of our long-term incentive compensation programs (which include the
granting of Phantom Stock Rights and Dividend Equivalent Rights) are fully
expensed in our statements of operations, are fully disclosed in our financial
reports and have been approved by our shareholders. At present, we do not have
any unexercised stock options outstanding.

GENERAL

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

22

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

We also invest in hybrid ARM assets ("Hybrid ARMs") which are typically 30-year
loans 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.

ARM assets are generally subject to periodic caps. Periodic caps generally limit
the maximum interest rate coupon change on any interest rate coupon adjustment
date to either a maximum of 1% per semiannual adjustment or 2% per annual
adjustment. The borrowings that we incur do not have similar periodic caps. We
generally do not hedge against the risk of our borrowing costs rising above the
periodic interest rate cap level on the ARM assets because the contractual
future interest rate adjustments on the ARM assets will cause their interest
rates to increase over time and reestablish the ARM assets' interest rate to a
spread over the then current index rate. We attempt to mitigate the effect of
periodic caps by acquiring variable rate CMOs and CBOs, Hybrid ARMs and certain
other ARM loans that do not have a periodic cap. As of June 30, 2002,
approximately $7.0 billion of our ARM securities and ARM loans did not have
periodic caps or were Hybrid ARMs, representing approximately 78% of total ARM
assets.

Our investment policy is to invest at least 70% of total assets in High Quality
ARM assets and short term investments. High Quality means:

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

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

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

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

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

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

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

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

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

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

We acquire and originate high quality mortgage loans through TMHL from three
sources: (i) bulk acquisitions, which involve acquiring pools of whole loans
which are originated using the seller's guidelines and underwriting

23

criteria, (ii) correspondent lending, which involves acquiring loans from
correspondent lenders or other loan originators who originate the individual
loans using our underwriting criteria and guidelines, and (iii) direct retail
loan originations, which are loans that we originate, including fixed rate loans
that we underwrite to third party specifications and sell to third party
investors. The loans that we acquire or originate are financed through warehouse
borrowing arrangements and securitized for our portfolio or, in the case of
fixed rate loans, sold to third parties.

We perform our own underwriting reviews of loans that we purchase from bulk
sellers or acquire from approved correspondents. We use private label,
fee-based, third party service providers to underwrite, process and close the
loans that we originate. We also service mortgage loans that we acquire or
originate using a contract, private label subservicer. We believe the
efficiencies and expertise that our third party service providers have developed
through specialization afford us an opportunity to enter the mortgage
origination and loan servicing business in a cost effective manner with minimum
initial investment.

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

We offer mortgages on-line utilizing a third party, private label, web-based
origination system. Prospective borrowers are able to look up mortgage loan
product and interest rate information through our website, obtain access to a
variety of mortgage calculators and consumer help features, submit an
application on-line and obtain a pre-approval of their loan. Once a mortgage
loan application has been submitted, one of our representatives will assist the
borrower in completing the loan process.

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

FINANCIAL CONDITION

At June 30, 2002, we held total assets of $8.943 billion, $8.865 billion of
which consisted of ARM assets, as compared to $5.804 billion and $5.732 billion,
respectively, at December 31, 2001. Since commencing operations, we have
primarily purchased either ARM securities (backed by agencies of the U.S.
government or 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 June
30, 2002, 94.8% of the assets that we held, including cash and cash equivalents,
were High Quality assets, far exceeding our investment policy minimum
requirement of investing at least 70% of our total assets in High Quality ARM
assets and cash and cash equivalents. Of the ARM assets that we owned as of June
30, 2002, 85.8% are in the form of adjustable rate pass-through certificates or
ARM loans. The remainder are floating rate classes of CMOs (8.2%), short term,
fixed rate classes of CMOs (4.0%) or investments in floating rate classes of
CBOs (2.0%) backed primarily by ARM MBS.

24

The following table presents a schedule of ARM assets owned at June 30, 2002 and
December 31, 2001 classified by High Quality and Other Investment assets and
further classified by type of issuer and by ratings categories.

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

- ----------

(1) The AAA Rating category includes $324.2 million and $442.2 million of
whole loans as of June 30, 2002 and December 31, 2001, 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 in the amount of $31.7 million and $31.8 million
as of June 30, 2002 and December 31, 2001, respectively. The
subordinated certificate is included in the BB/Ba Rating and Other
category.

As of June 30, 2002 and December 31, 2001, we had reduced the carrying value of
our securitized ARM loans by $10,510,000 and $7,925,000, respectively, due to
estimated credit losses (other than temporary declines in fair value). In
addition, we had reduced the cost basis of other ARM securities by $1,002,000
and $1,151,000, as of the same dates, respectively, related to Other Investments
that we purchased at a discount that included an estimate of credit losses.

As of June 30, 2002, our ARM loan portfolio included 8 loans that are considered
seriously delinquent (60 days or more delinquent) with an aggregate balance of
$2.2 million. The ARM loan portfolio also includes two properties that we
acquired as the result of foreclosure procedures in the amount of $508,000. The
average original effective loan-to-value ratio on the delinquent loans and the
acquired properties is approximately 58%. We believe that our current level of
basis adjustments and allowance for loan losses is more than adequate to cover
estimated losses from these loans and properties.

25

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

The following table classifies our portfolio of ARM assets by type of interest
rate index.

ARM ASSETS BY INDEX
(Dollar amounts in thousands)

The ARM portfolio had a current weighted average interest rate coupon of 5.27%
at June 30, 2002. This consisted of an average coupon of 5.48% on the hybrid
portion of the portfolio and an average coupon of 4.97% on the rest of the
portfolio. If the non-hybrid portion of the portfolio had been "fully indexed,"
the weighted average coupon of the non-hybrid portion of the portfolio would
have been approximately 4.43%, 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.

The ARM portfolio had a current weighted average interest rate 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 at that time. The lower average interest rate coupon on the ARM
portfolio as of June 30, 2002 compared to the end of 2001 is reflective of the
Federal Reserve Board interest rate decreases that occurred during 2001. The
average interest rate on the ARM portion of the portfolio is expected to
continue to decrease during 2002 until it reaches the "fully indexed" rate.

26

At June 30, 2002, the current yield of the ARM assets portfolio was 4.99%,
compared to 5.09% as of December 31, 2001. The decrease in the yield of 0.10% as
of June 30, 2002, compared to December 31, 2001, is due to the decreased
weighted average interest rate coupon discussed above, which decreased by 0.69%.
This decline in the average interest rate coupon was partially offset by a lower
level of net premium amortization, which had the effect of increasing the yield
by 0.49%. Additionally, the impact of non-interest earning principal payments
receivables also increased the portfolio yield by 0.10%. The current yield
includes the impact of the amortization of applicable premiums and discounts and
the impact of principal payment receivables.

The ARM portfolio had an average term to the next repricing date of 777 days as
of June 30, 2002, compared to 617 days as of December 31, 2001. The non-hybrid
portion of the portfolio had an average term to the next repricing date of 64
days and the hybrid portion had an average term to the next repricing date of
3.5 years at June 30, 2002. As of June 30, 2002, Hybrid ARMs comprised 58.5% of
the total ARM portfolio, compared to 41.7% as of the end of 2001. 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. Therefore, many of our borrowings bear variable or short term
(one year or less), fixed interest rates because many of our ARM assets have
interest rates that adjust within one year. However, we finance our Hybrid ARM
portfolio with longer term, fixed rate borrowings such that the duration
difference of the fixed interest rate period 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 difference of less than
one year, the price change of our Hybrid ARM portfolio is expected to be a
maximum of 1% for a 1% parallel shift in interest rates net of the fair value
change of our Swap Agreements and other borrowings funding our Hybrid ARMS. As
of June 30, 2002, the duration difference applicable to our Hybrid ARM portfolio
was approximately three months.

27

The following table presents various characteristics of our ARM and Hybrid ARM
loan portfolio as of June 30, 2002. This information pertains to loans held for
securitization, loans held as collateral for notes payable and loans securitized
for our own portfolio for which we retained credit loss exposure. The combined
amount of the loans included in this information is $2.730 billion.

ARM AND HYBRID ARM LOAN PORTFOLIO CHARACTERISTICS

Geographic distribution (top 5 states): Property type:
California 30.12% Single-family 63.46%
Georgia 12.02 DeMinimus PUD 24.04
Colorado 5.91 Condominium 7.96
New York 5.84 Other 4.54
Florida 5.84

Occupancy status: Loan purpose:
Owner occupied 86.71% Purchase 37.62%
Second home 10.91 Cash out refinance 29.42
Investor 2.38 Rate & term refinance 32.96

Documentation type: Periodic Cap:
Full/Alternative 93.62% None 24.75%
Other 6.38 1.00% or less 1.99
2.00% 72.68
Over 2.00% 0.58

Average effective original Percent of loan balances
loan-to-value: 68.69% that are interest only: 75.47%

As of June 30, 2002, we serviced $1.0 billion of our loans and had 2,545
customer relationships. We hold all of the loans that we service in our
portfolio in the form of securitized loans or loans to be securitized for our
portfolio. We have not retained or capitalized any servicing rights on loans
sold.

28

During the quarter ended June 30, 2002, we purchased $1.9 billion of ARM
securities, 100% of which were High Quality assets, and $618.5 million of ARM
loans, generally originated to "A" quality underwriting standards. Of the ARM
assets that we acquired during the three months ended June 30, 2002,
approximately 80% were Hybrid ARMs, 6% were fixed rate, short term securities,
13% were indexed to LIBOR and 1% were indexed to U.S. Treasury bill rates. The
following table compares our ARM asset acquisition and origination activity for
the consecutive quarters ended June 30, 2002 and March 31, 2002 (dollar amounts
in thousands):

Since 1997, we have emphasized purchasing ARM and Hybrid ARM assets; high
quality, floating rate collateralized mortgages and short term, fixed rate
securities at substantially lower prices relative to par in order to reduce the
potential impact of rapid prepayments. . In doing so, the average
premium/(discount) that we paid for ARM assets acquired in the first six months
of 2002 and for the year 2001 was 0.65% and 0.12% of par, respectively, as
compared to 3.29% of par in 1997 when we emphasized the purchase of seasoned ARM
assets. In part, as a result of this strategy, our unamortized net premium as a
percent of par decreased to 0.89% as of June 30, 2002, compared to 0.94% as of
December 31, 2001 and down from 2.83% as of the end of 1997.

During the three month and six month periods ended June 30, 2002, we securitized
$508.3 million and $957.8 million of our ARM loans into a series of privately
issued multi-class ARM securities, all of which we retained for our ARM
portfolio. We securitize the ARM loans that we acquire into ARM securities for
our 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 our
portfolio, thereby improving our access to mortgage finance markets. In doing
so, we retain all of the economic interest and risk of the loans, except those
swapped for Fannie Mae guaranteed certificates. Of the loans that we securitized
during the first six months of 2002, 99.7% were at least Investment Grade
securities and 0.3% were subordinate securities that provide credit support to
the Investment Grade securities.

As of June 30, 2002, we had commitments to purchase $180.4 million of ARM
securities and $338.3 million of ARM loans through retail channels.

During the three month period ended June 30, 2002, we sold $12.6 million of ARM
securities for a gain of $95,000 and one loan for a loss of $11,000, resulting
in a net gain of $84,000. During the three month period ended June 30, 2001, we
sold $108.1 million of ARM securities and realized $244,000 in gains and
$245,000 in losses. In addition, we sold $0.3 million of fixed rate loans that
we had originated during the second quarter of 2001 for a gain of $3,000.

For the quarter ended June 30, 2002, our mortgage assets paid down at an
approximate average annualized Constant Paydown Rate ("CPR") of 26% compared to
28% for the quarter ended June 30, 2001 and 34% for the quarter ended March 31,
2002. When prepayment experience increases, we have to amortize our premiums
over a shorter time period, resulting in a reduced yield to maturity on our ARM
assets. Conversely, if actual prepayment experience decreases, we would amortize
the premium over a longer time period, resulting in a higher yield to maturity.
We

29

monitor our prepayment experience on a monthly basis in order to adjust the
amortization of the net premium, as appropriate.

The fair value of our portfolio of ARM assets classified as available-for-sale
increased by 0.24% from a negative adjustment of 0.10% of the portfolio as of
December 31, 2001, to a positive adjustment of 0.14% as of June 30, 2002. This
price improvement was primarily due to the effect of declining medium to
long-term interest rates on the fair value of our Hybrid ARM assets. The amount
of the adjustment to the fair value on the ARM assets classified as
available-for-sale improved from a negative adjustment of $5.3 million as of
December 31, 2001, to a positive adjustment of $11.2 million as of June 30,
2002. All of our ARM securities are classified as available-for-sale and are
carried at their fair value.

Our ARM assets generally have a maximum lifetime interest rate cap or ceiling,
meaning that each ARM asset contains a contractual maximum interest rate. Since
our borrowings are not subject to equivalent interest rate caps, we enter into
Cap Agreements which have the effect of offsetting a portion of our borrowing
costs, thereby reducing the effect of the lifetime cap feature on our ARM assets
and protecting the net margin on our ARM assets in high interest rate
environments. At June 30, 2002, our Cap Agreements had a remaining notional
balance of $2.205 billion with an average final maturity of 1.3 years, compared
to a remaining notional balance of $2.254 billion with an average final maturity
of 1.5 years at December 31, 2001. At June 30, 2002, the fair value of our Cap
Agreements was $0.3 million compared to a fair value of $0.4 million as of
December 31, 2001. Pursuant to the terms of the Cap Agreements, we will receive
cash payments if the one month or three month LIBOR indices increase above
certain specified levels, which range from 6.00% to 12.00% and average
approximately 9.90%.

The following table presents information about our Cap Agreement portfolio as of
June 30, 2002:

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

- ----------
(1) Excludes ARM assets that do not have lifetime interest rate caps or are
hybrids that are match funded during their fixed rate period, in
accordance with our investment policy.

We enter into interest rate Swap Agreements in order to manage our interest rate
exposure when financing our ARM assets. We generally borrow money based on short
term interest rates, either by entering into borrowings with maturity terms
ranging from one month to six months or by entering into borrowings with longer
maturity terms of one to two years that reprice based on a frequency ranging
from one month to six months. Our ARM assets generally have interest rates that
reprice based on frequency terms of one to twelve months. Our Hybrid ARMs
generally have an initial fixed interest rate period of three to ten years. As a
result, our existing and forecasted borrowings reprice to a new interest rate on
a more frequent basis than do our ARM assets. When we enter into a Swap
Agreement, we agree to pay a fixed rate of interest and to receive a variable
interest rate based on LIBOR. These Swap Agreements have the effect of
converting our variable rate debt into fixed rate debt over the life of the Swap
Agreements. We use Swap Agreements as a cost effective way to lengthen the
average repricing period of our

30

variable rate and short term borrowings such that the average repricing period
of our borrowings more closely matches the average repricing period of our ARM
assets.

As of June 30, 2002, we were a counterparty to forty-eight Swap Agreements
having an aggregate notional balance of $3.796 billion. These Swap Agreements
hedged our short-term financing during the fixed interest rate period of the
Hybrid ARM assets we held in our portfolio and had a weighted average maturity
of 2.5 years. Entering into these Swap Agreements has enabled us to reduce the
interest rate variability of the cost to finance our Hybrid ARM assets by
increasing the average period until the next repricing of the associated
borrowings from 39 days to 746 days. The average remaining fixed rate term of
our Hybrid ARM assets as of June 30, 2002 was 3.5 years. Further, the difference
between the duration of Hybrid ARMs and the duration of the borrowings funding
Hybrid ARMs, as of June 30, 2002, was approximately three months.

In accordance with Financial Accounting Standards No. 133 ("FAS 133"), we
designate all of these Swap Agreements as cash flow hedges and, as of June 30,
2002, carry them on the balance sheet at their negative fair value of $59.8
million. As of June 30, 2002, the fair value adjustment for Swap Agreements was
a decrease to "Accumulated other comprehensive income" in the amount of $55.9
million. 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, and we have calculated the effectiveness of
this cash flow hedge to be approximately 100%. As a result, we have recorded all
changes in the unrealized gains and losses on Swap Agreements in "Accumulated
other comprehensive income" and we have reclassified all such changes to
earnings as interest expense is recognized on our hedged borrowings.

RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED JUNE 30, 2002

For the quarter ended June 30, 2002, our net income was $27,938,000, or $0.63
per share (Basic and Diluted EPS), based on a weighted average of 41,950,000
shares outstanding. That compares to $11,639,000, or $0.46 per share (Basic and
Diluted EPS) for the quarter ended June 30, 2001, based on a weighted average of
21,791,000 shares outstanding, a 37% increase in our earnings per share.

The table below highlights the historical trend, 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 of our manager, Thornburg Mortgage Advisory Corporation (the
"Manager"):

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.

31

Our return on average common equity was 16.01% for the quarter ended June 30,
2002 compared to 11.73% for the quarter ended June 30, 2001. Our return on
equity improved in this past quarter compared to the same quarter of the prior
year primarily because our net interest income improved. This improvement was
due, in part, to the lower cost of funds of our borrowings and because the yield
on our net interest earning assets is benefiting from acquisitions of loans and
other ARM and Hybrid ARM assets acquired at average prices close to par,
replacing lower yielding assets that paid off.

The following table presents the components of our net interest income:

COMPARATIVE NET INTEREST INCOME COMPONENTS
(Dollar amounts in thousands)

As presented in the table above, our net interest income increased by $21.2
million in the second quarter of 2002 compared to the second quarter of 2001.
The change was attributable to a $28.8 million increase in interest income due
to an increased asset base, partially offset by a $7.5 million increase in
interest expense as a result of higher interest rates. The following two tables
explain the increase in terms of volume and rate variances.

32

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

AVERAGE BALANCE, RATE AND INTEREST INCOME/EXPENSE TABLE
(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.

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 result of the yield on our interest-earning assets decreasing to 4.91%
during the second quarter of 2002 from 6.15% during the same period of 2001, a
decrease of 1.23%, and our cost of funds decreasing even more to 3.35% from
5.19% during the same time period, a decrease of 1.84%, net interest income
increased by $21,243,000. This increase in net interest income is both a
favorable rate variance and a favorable volume variance. There was a net
favorable rate variance of $5,556,000, primarily due to a favorable rate
variance on borrowings that increased net interest income by $19,121,000,
partially offset by an unfavorable rate variance on our ARM assets portfolio and
other interest-earning assets in the amount of $13,565,000. The increased
average size of our portfolio during the

33

second quarter of 2002 compared to the same period in 2001 increased net
interest income in the amount of $15,687,000. The average balance of our
interest-earning assets was $7.846 billion during the second quarter of 2002,
compared to $4.394 billion during the same period of 2001 -- an increase of
78.6%.

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 the components of the yield adjustments for the
dates presented in the table above.

COMPONENTS OF THE YIELD ADJUSTMENTS ON ARM ASSETS

We recorded hedging expense during the second quarter of 2002 of $622,000. At
June 30, 2002, the fair value of our Cap Agreements was $257,000 compared to a
fair value of $212,000 as of March 31, 2002, a decrease in fair value of
$460,000, after adjusting for purchasing Cap Agreements during the second
quarter for $505,000. Since we are not currently applying hedge accounting to
our Cap Agreements, we recorded this change in fair value of the Cap Agreements
as hedging expense during the quarter ended June 30, 2002. Additionally, during
the second

34

quarter of 2002, we reclassified to earnings $149,000 of the transition
adjustment recorded in "Accumulated other comprehensive income" on January 1,
2001, in connection with the implementation of FAS 133 and recorded other
hedging expenses in the amount of $13,000.

During the second quarter of 2001, we recorded a hedging expense of $466,000. At
June 30, 2001, the fair value of our Cap Agreements and Option Contracts was
$0.6 million compared to a fair value of $0.5 million as of March 31, 2001. In
accordance with FAS 133, this change in the fair value of the Cap Agreements and
Option Contracts was compared to the change in the fair value of the lifetime
interest rate cap component of our ARM assets, the hedged assets. As a result,
we determined that the fair value hedge met the effectiveness requirements of
FAS 133 to qualify for fair value hedge accounting treatment and we recorded the
ineffective portion of $466,000 as a hedging expense. The ineffective portion is
measured as the change in the hedge instruments in excess of the change in the
hedged assets.

Since we began acquiring whole loans in 1997, we have only experienced losses on
three loans, for a total amount of $174,000. We continue to evaluate our
estimated credit losses on loans that are not expected to be securitized and on
loans prior to their securitization and we may readjust our current policy if
the circumstances so warrant. As of June 30, 2002, our whole loans, including
those held as collateral for notes payable and those that we have securitized
but with respect to which we have retained credit loss exposure, accounted for
31.2% of our portfolio of ARM assets or $2.730 billion.

For the quarter ended June 30, 2002, our ratio of operating expenses to average
assets was 0.43% compared to 0.31% for the same period in 2001 and 0.44% for the
prior quarter ended March 31, 2002. The most significant single increase to our
expenses was the performance-based fee of $3,721,000 that the Manager earned
during the second quarter of 2002 as a result of our achieving a return on
shareholders' equity in excess of the threshold as defined in the management
agreement that we entered into with the Manager (the "Management Agreement").
Our return on equity prior to the effect of the performance-based fee was 18.28%
whereas the threshold, the average 10-year treasury rate plus 1%, was 6.11%. Our
other expenses increased by approximately $1,589,000 from the second quarter of
2001 to the second quarter of 2002, primarily due to the operations of TMHL,
expenses associated with our issuance of Dividend Equivalent Rights ("DERs") and
Phantom Stock Rights ("PSRs"), and other corporate matters. TMHL's operations
accounted for $890,000 of this increase and our issuance of DERs and PSRs
accounted for $659,000 of the increase. Our expense ratios are among the lowest
of any company originating and investing in mortgage assets, giving us what we
believe to be a significant competitive advantage over more traditional mortgage
portfolio lending institutions such as banks and savings and loan institutions.
This competitive advantage enables us to operate with less risk, such as credit
and interest rate risk, and still generate an attractive long-term return on
equity when compared to more traditional mortgage portfolio lending
institutions.

We pay the Manager an annual base management fee, generally based on average
shareholders' equity as defined in the Management Agreement, payable monthly in
arrears as follows: 1.18% of the first $300 million of average shareholders'
equity, plus 0.85% of average shareholders' equity above $300 million, subject
to an annual inflation adjustment based on changes in the Consumer Price Index.
Since the management fee is based on shareholders' equity and not assets, the
fee increases as we raise additional equity capital and thereby manage a larger
amount of invested capital on behalf of our shareholders. In order for the
Manager to earn a performance fee, the rate of return on the shareholders'
investment, as defined in the Management Agreement, must exceed the average
10-year U.S. Treasury rate during the quarter plus 1%. As presented in the
following table, the performance fee is a variable expense that fluctuates with
our return on shareholders' equity relative to the average 10-year U.S. Treasury
rate.

35

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

ANNUALIZED OPERATING EXPENSE RATIOS

RESULTS OF OPERATIONS FOR THE SIX MONTHS ENDED JUNE 30, 2002

For the six months ended June 30, 2002, our net income was $52,231,000, or $1.25
per share (Basic and Diluted EPS), based on a weighted average of 39,199,000
shares outstanding. That compares to $22,366,000, or $0.88 per share (Basic and
Diluted EPS), for the six months ended June 30, 2001, based on a weighted
average of 21,741,000 shares outstanding, a 42% increase in our earnings per
share.

Our return on average common equity was 16.26% for the six months ended June 30,
2002 compared to 11.37% for the six months ended June 30, 2001. Our return on
equity improved in this past quarter compared to the same quarter of the prior
year primarily because our net interest income improved. This improvement was
due, in part, to the lower cost of funds of our borrowings and because our yield
on net interest earning assets is benefiting from acquisitions of loans and
other ARM and Hybrid ARM assets acquired at average prices close to par,
replacing lower yielding assets that paid off.

The following table presents the components of our net interest income for the
six month periods ended June 30, 2002 and 2001:

COMPARATIVE NET INTEREST INCOME COMPONENTS
(Dollar amounts in thousands)

As presented in the table above, our net interest income increased by $38.5
million in the first half of 2002 compared to the same six months of 2001. The
change was attributable to a $35.0 million increase in interest income due to an
increased asset base and a $3.5 million decline in interest expense as a result
of lower rates.

36

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

AVERAGE BALANCE, RATE AND INTEREST INCOME/EXPENSE TABLE
(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.

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 result of the yield on our interest-earning assets decreasing to 4.93%
during the first half of 2002 from 6.51% during the same period of 2001, a
decrease of 1.58%, and our cost of funds decreasing to 3.33% from 5.62% during
the same time period, a decrease of 2.29%, net interest income increased by
$38,543,000. This increase in net interest income is both a favorable rate
variance and a favorable volume variance. There was a net favorable rate
variance of $12,782,000, primarily due to a favorable rate variance on
borrowings that increased net interest income by $46,583,000, partially offset
by an unfavorable rate variance on our ARM assets portfolio and other
interest-earning assets in the amount of $33,801,000. The increased average size
of our portfolio during the first half of 2002 compared to the same period in
2001 increased net interest income in the amount of $25,761,000. The average

37

balance of our interest-earning assets was $7.214 billion during the first half
of 2002, compared to $4.327 billion during the same period of 2001 -- an
increase of 66.7%.

During the first half of 2002, we realized a net gain from the sale of ARM
securities and fixed-rate loans in the amount of $87,000 as compared to $2,000
during the first half of 2001. The sale of ARM securities during the first six
months of 2002 resulted in a net gain of $95,000 and the sale of fixed rate
loans by TMHL resulted in a net loss of $8,000. The gain from the sale of ARM
assets during 2001 was a result of the sale of ARM securities and fixed rate
loans.

For the six months ended June 30, 2002, our ratio of operating expenses to
average assets was 0.43% as compared to 0.30% for the same period of 2001.
During the first six months of 2002, the Manager earned a performance-based fee
of $6,914,000 or 0.19% of average assets. The Manager earned a performance-based
fee of $1,997,000 during the same six months of 2001. Our other expenses
increased by approximately $2,725,000 for the six months ended June 30, 2002
compared to the same six month period in 2001, primarily due to the operations
of TMHL, expenses associated with our issuance of DERs and PSRs, and due to
other corporate matters. TMHL's operations accounted for $1,593,000 of this
increase and our issuance of DERs, PSRs and restricted stock accounted for
$958,000 of the increase.

LIQUIDITY AND CAPITAL RESOURCES

Our primary source of funds for the quarter ended June 30, 2002 consisted of
reverse repurchase agreements which totaled $7.554 billion, collateralized notes
payable which had a balance of $316.8 million, and whole loan financing
facilities which had a balance of $280.8 million. Our other significant sources
of funds for the quarter ended June 30, 2002 consisted primarily of payments of
principal and interest from our ARM assets in the amount of $832.8 million. In
the future, we expect our primary sources of funds to 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 our ARM assets portfolio and
occasional asset sales. Our liquid assets generally consist of unpledged ARM
assets, cash and cash equivalents.

Total borrowings outstanding at June 30, 2002 had a weighted average effective
cost of 2.06%. The reverse repurchase agreements had a weighted average
remaining term to maturity of 3.8 months and the collateralized AAA 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 March 2003 and November 2003.
As of June 30, 2002, $3.400 billion of our borrowings were variable rate term
reverse repurchase agreements. Term reverse repurchase agreements are committed
financings with original maturities that range from three to eighteen 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 the one
month LIBOR rate. 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.

We have arrangements to enter into reverse repurchase agreements with
twenty-five different financial institutions and on June 30, 2002, we had
borrowed funds from fourteen of these firms. Because we borrow money under these
agreements based on the fair value of our ARM assets and because changes in
interest rates can negatively impact the valuation of ARM assets, our borrowing
ability under these agreements may be limited and lenders may initiate margin
calls in the event interest rates change or the value of our ARM assets decline
for other reasons. Additionally, approximately 1.5% of our ARM assets are rated
less than AA by the Rating Agencies 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 changes in interest rates, credit performance of a
mortgage pool or a downgrade of a mortgage pool issuer, we 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, such sales could be
at prices lower than the carrying value of the assets, which would result in
losses. We had adequate liquidity throughout the quarter ended June 30, 2002. We
believe that we will continue to have sufficient liquidity to meet our future
cash requirements from our primary sources of funds for the foreseeable future
without needing to sell assets.

38

As of June 30, 2002, we had $316.8 million of AAA collateralized notes payable
outstanding, which are not subject to margin calls. Due to the structure of the
collateralized notes payable, 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.

As of June 30, 2002, we had entered into three whole loan financing facilities.
We borrow money under these facilities based on the fair value of the ARM loans.
Therefore, the amount of money available to us under these facilities is subject
to margin call based on changes in fair value, which can be negatively affected
by changes in interest rates and other factors, including the delinquency status
of individual loans. One of the whole loan financing facilities has a committed
borrowing capacity of $300 million and matures in March 2003. Our other two
committed whole loan financing facilities also have a borrowing capacity of $300
million each and they both mature in November 2002. As of June 30, 2002, we had
$280.8 million borrowed against these whole loan financing facilities at an
effective cost of 2.50%.

On May 31, 2001, we filed a combined shelf registration statement on Form S-3
for $409 million of equity securities including common stock, preferred stock or
warrants, which included $109 million of securities that were registered under a
previously filed registration statement. On July 6, 2001, the Securities and
Exchange Commission (the "SEC") declared the combined registration statement
effective. During February 2002, we completed a public offering of 6,210,000
shares of our common stock, for which we received net proceeds of $113.5
million. During both the three and six-month periods ended June 30, 2002, we
issued 2,530,800 shares of common stock under a continuous equity offering
program and received net proceeds of $48.3 million. As of June 30, 2002, $76.3
million of our securities remained registered for future issuance and sale under
our currently effective registration statement.

We have 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 our 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. During the
three and six-month periods ended June 30, 2002, we issued 927,592 and 2,312,812
shares, respectively, of common stock under our Dividend Reinvestment and Stock
Purchase Plan and received net proceeds of $18.5 and $45.8 million,
respectively.

EFFECTS OF INTEREST RATE CHANGES

Changes in interest rates impact our earnings in various ways. While we invest
primarily in ARM assets, rising short term interest rates may temporarily
negatively affect our earnings and conversely falling short term interest rates
may temporarily increase our earnings. This impact can occur for several reasons
and may be mitigated by portfolio prepayment activity as discussed below. First,
our borrowings will react to changes in interest rates sooner than our ARM
assets because the weighted average next repricing date of the borrowings is
usually a shorter time period than that of the ARM assets. Second, interest
rates on non-hybrid ARM assets may be limited to an increase of either 1% or 2%
per adjustment period (commonly referred to as the periodic cap) and our
borrowings do not have similar limitations. At June 30, 2002, 21.6% of our total
ARM assets are non-hybrid ARM assets subject to periodic caps. Third, our ARM
assets lag changes in the applicable interest rate indices due to the notice
period provided to ARM borrowers when the interest rates on their loans are
scheduled to change.

Interest rates can also affect our net return on Hybrid ARMs (net of the cost of
financing Hybrid ARMs). We estimate the duration of the fixed rate period of our
Hybrid ARMs and have a policy to hedge the financing of the Hybrid ARMs such
that the duration difference between our borrowed funds and the Hybrid ARM
assets is less than one year. The cost of financing 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 our cost of short-term funds is higher at the expiration of the
hedged period, our net interest spread on the remaining balance of a Hybrid ARM
asset will be affected unfavorably and conversely, if our cost of short-term
funds is lower, the net interest spread will be affected favorably. In addition,
during a declining interest rate environment, the prepayment of Hybrid ARMs may
accelerate causing the amount of fixed rate financing to increase relative to
the amount of Hybrid ARMs, possibly resulting in a decline in our net return on
Hybrid ARMs as replacement Hybrid ARMs may have a lower yield than the ones
paying off. In contrast, during an increasing

39

interest rate environment, Hybrid ARMs may prepay slower than expected,
requiring us to finance a higher amount of Hybrid ARMs than originally
anticipated at a time when interest rates may be higher, resulting in a decline
in our net return on Hybrid ARMs. In order to manage our exposure to changes in
the prepayment speed of Hybrid ARMs, we regularly monitor the balance of Hybrid
ARMs and make adjustments to the amounts anticipated to be outstanding in future
periods and, on a regular basis, make adjustments to the amount of our
fixed-rate borrowing obligations in future periods.

Interest rate changes may also impact our ARM assets and borrowings differently
because our ARM assets are indexed to various indices whereas the interest rate
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 ARM assets 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. During times of global economic
instability, U.S. Treasury rates generally decline as foreign and domestic
investors generally increase their investment in U.S. Treasury instruments
because they are considered to be a safe haven for investments. Our non-hybrid
ARM assets indexed to U.S. Treasury rates then decline in yield as U.S. Treasury
rates decline, whereas our borrowings and other non-hybrid 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 to which our non-hybrid ARM assets are indexed, compared to changes in
our cost of funds. At June 30, 2002, 14.9% of our ARM assets were non-hybrid ARM
assets indexed to U.S. Treasury rates.

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

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

Lastly, because we invest primarily in ARM assets and approximately 8% to 10% of
such assets are purchased with shareholders' equity, our earnings, over time,
will tend to increase, after an initial short term decline, following periods
when short term interest rates have risen, and decrease after an initial short
term increase, following periods when short term interest rates have declined.
This is because the financed portion of our portfolio of ARM assets will, over
time, reprice to a spread over our cost of funds, while the portion of our
portfolio of ARM assets that is 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

As of June 30, 2002, we calculated our Qualified REIT Assets, as defined in the
Internal Revenue Code of 1986, as amended (the "Code"), to be 99.7% of our total
assets, as compared to the Code requirement that at least 75% of our total
assets must be Qualified REIT Assets. We also calculated that 99.6% of our 2002
revenue for the first six months of 2002 qualifies for the 75% source of income
test and 100% of our revenue qualifies for the 90% source of income test under
the REIT rules. We also met all REIT requirements regarding the ownership of our
common stock and the distributions of our net income. Therefore, as of June 30,
2002, we believe that we will continue to qualify as a REIT under the provisions
of the Code.

We at all times intend to conduct our business so as not to become regulated as
an investment company under the Investment Company Act of 1940, as amended. If
we were to become regulated as an investment company, then our use of leverage
would be substantially reduced. The Investment Company Act exempts entities that
are "primarily engaged in the business of purchasing or otherwise acquiring
mortgages and other liens on and interests

40

in real estate" ("Qualifying Interests"). Under current interpretation of the
staff of the SEC, in order to qualify for this exemption, we must maintain at
least 55% of our assets directly in Qualifying Interests as defined in the Code.
In addition, unless certain mortgage securities represent all the certificates
issued with respect to an underlying pool of mortgages, such mortgage securities
may be treated as securities separate from the underlying mortgage loans and,
thus, may not be considered Qualifying Interests for purposes of the 55%
requirement. We calculated that we are in compliance with this requirement.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings
At June 30, 2002, there were no pending legal proceedings to which
we were a party or of which any of our property was subject.

Item 2. Changes in Securities
Not applicable

Item 3. Defaults Upon Senior Securities
Not applicable

Item 4. Submission of Matters to a Vote of Security Holders
(a) Our Annual Meeting of Shareholders was held on April 25, 2002.
(b) Election of Class II Directors

The following Class I and Class III directors continued in
office after the Annual Meeting:

David A. Ater
Joseph H. Badal
Larry A. Goldstone
Ike Kalangis
Stuart C. Sherman
Garrett Thornburg

(c) Approval of an amendment to our Articles of Incorporation to
increase the authorized capital stock to 500,000,000 shares.

Item 5. Other Information
The registrant is also filing its 2002 Long-Term Incentive
Plan which was approved by its Board of Directors on July 23,
2002 and which will be submitted for shareholder approval at
the 2003 Annual Meeting of Shareholders. The new plan will
become effective following the expiration of the existing 1992
Stock Option and Incentive Plan when it expires on September
28, 2002.

The Company is also filing its Limited Stock Repurchase Plan,
which was approved by the Company's Board of Directors on
April 23, 2002 for the purpose of facilitating the repayment
of

41

outstanding notes receivable from stock sales in connection
with the exercise of options to purchase stock.

Item 6. Exhibits and Reports on Form 8-K:

(a) Exhibits
See "Exhibit Index"

(b) Reports on Form 8-K
None

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized,

THORNBURG MORTGAGE, INC.

Dated: August 12, 2002 By: /s/ Larry A. Goldstone
---------------------------------------
Larry A. Goldstone
President and Chief Operating Officer
(authorized officer of registrant)

Dated: August 12, 2002 By: /s/ Richard P. Story
---------------------------------------
Richard P. Story,
Executive Vice President, Chief
Financial Officer and Treasurer
(principal accounting officer)

43

EXHIBIT INDEX