UNITED STATES SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

For the quarterly period ended: March 31, 2004

OR

For the transition period from                      to                     

Commission File Number: 001-11914

THORNBURG MORTGAGE, INC.

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

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

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

Yes x           No o

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934).

Yes x            No o

APPLICABLE ONLY TO CORPORATE ISSUERS:

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

Common Stock ($.01 par value) 81,134,145 as of May 3, 2004

INDEX

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PART I. FINANCIAL INFORMATION

Item 1. FINANCIAL STATEMENTS

THORNBURG MORTGAGE, INC. AND SUBSIDIARIES

See Notes to Consolidated Financial Statements.

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THORNBURG MORTGAGE, INC. AND SUBSIDIARIES

See Notes to Consolidated Financial Statements.

4

THORNBURG MORTGAGE, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)

See Notes to Consolidated Financial Statements.

5

THORNBURG MORTGAGE, INC. AND SUBSIDIARIES

See Notes to Consolidated Financial Statements.

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THORNBURG MORTGAGE, INC. AND SUBSIDIARIES

Supplemental disclosure of cash flow information and non-cash activities is included in Note 4.
See Notes to Consolidated Financial Statements

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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.

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 ended March 31, 2004 are not necessarily indicative of the results that may be expected for the calendar year ending December 31, 2004. The interim financial information should be read in conjunction with Thornburg Mortgage, Inc.’s 2003 Annual Report on Form 10-K/A.

Basis of presentation and principles of consolidation

The consolidated financial statements include the accounts of Thornburg Mortgage, Inc. (together with its subsidiaries referred to hereafter as the “Company”) and its wholly owned bankruptcy-remote special purpose finance subsidiaries, Thornburg Mortgage Funding Corporation (“TMFC”) and Thornburg Mortgage Acceptance Corporation (“TMAC”), its wholly owned mortgage loan origination 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. All of the Company’s subsidiaries are wholly owned qualified real estate investment trust (“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 prior period amounts have been reclassified to conform to current period classifications.

Recently adopted accounting pronouncements

On March 9, 2004, the SEC released Staff Accounting Bulletin 105 (“SAB 105”) providing guidance on how to account for a commitment to purchase a mortgage loan prior to funding the loan. SAB 105 is intended to eliminate the current diversity in practice that exists relating to the accounting for loan commitments. SAB 105 is effective for loan commitments entered into after March 31, 2003. Management believes that the Company’s method of accounting for loan commitments is consistent with the guidance provided by SAB 105.

Cash and cash equivalents

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

Restricted cash

Restricted cash is primarily cash collateral held by counter-parties in connection with reverse repurchase agreements and hedging instruments. The carrying amount of restricted cash approximates its fair value.

Adjustable-rate mortgage (“ARM”) assets

The Company’s ARM assets are comprised of ARM securities and securitized ARM loans, ARM loans collateralizing long-term debt and ARM loans held for securitization (the last three collectively referred to as “ARM Loans”). All of the Company’s ARM assets are either traditional ARM securities and loans, meaning they have interest rates that reprice in a year or less (“Traditional ARMs”), or hybrid ARM securities and loans that have a fixed interest rate for an initial period of three to ten years and then convert to Traditional ARMs for their remaining terms to maturity (“Hybrid ARMs”).

ARM securities are composed mainly of ARM securities purchased from third parties; also included in this balance are ARM securities relating to loans securitized by the Company prior to April 1, 2001. The Company has designated all of its ARM securities as available-for-sale. Therefore, they are reported at fair value, with unrealized gains and losses reported in Accumulated other comprehensive income (loss) as a separate component of shareholders’ equity. Any unrealized loss deemed to be other than temporary is recorded as realized loss. Realized

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gains or losses on the sale of ARM securities are recorded in earnings at the time of sale and are determined by the difference between net sale proceeds and the cost of the securities.

ARM Loans are designated as held-for-investment as the Company has the intent and ability to hold them for the foreseeable future, and until maturity or payoff. ARM Loans are carried at their unpaid principal balances, including unamortized premium or discount, unamortized loan origination costs, unamortized deferred loan origination fees and allowance for loan losses.

Securitized ARM loans are loans originated or acquired by the Company and securitized by the Company after March 31, 2001 with the Company retaining 100% of the beneficial ownership interests.

ARM loans collateralizing long-term debt are loans the Company has securitized that provide credit support for AAA certificates issued to third party investors in structured financing arrangements.

ARM loans held for securitization are loans the Company has acquired or originated and are intended to be securitized and retained by the Company.

The Company does not sell any of the securities created from its securitizations to generate gain on sale income. The loan securitization process benefits the Company by either creating highly liquid securitized assets that can be readily financed in the reverse repurchase agreement market or enabling the Company to enter into long-term collateralized debt obligations (“CDOs”) which represent permanent financing that is not subject to margin calls.

Interest income on ARM assets is accrued based on the outstanding principal amount and contractual terms of the assets. 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. Loan origination fees, net of certain direct loan origination costs, are deferred and amortized as an interest income yield adjustment over the life of the related loans using the effective yield method.

Credit risk and allowance for loan losses

The Company limits its exposure to credit losses on its portfolio of ARM securities by purchasing ARM securities that have an Investment Grade rating at the time of purchase and have some form of credit enhancement, or are guaranteed by an agency of the federal government (“Ginnie Mae”) or a government-sponsored or federally-chartered corporation (“Fannie Mae” or “Freddie Mac”) (collectively “Agency Securities”). An Investment Grade security generally has a security rating of BBB, Baa or better by at least one of two nationally recognized rating agencies, Standard & Poor’s, Inc. or Moody’s Investors Service, Inc. (the “Rating Agencies”). Additionally, the Company purchases and originates ARM loans or purchases all classes of a third party ARM loan securitization (including the classes rated less than Investment Grade). When the Company acquires classes of securities that are below Investment Grade, the purchase price generally includes a discount for probable credit losses; this reduction, or “basis adjustment”, is recorded as part of the purchase price of that security. In the event of impairment, the Company revises its estimate of probable losses and any difference between the initial estimate and the new estimate of losses is recorded in earnings. The Company limits its exposure to credit losses by restricting its investment in “Other Investments” to no more than 30% of total assets. Other Investments may include, among other items, securities that are rated A or less by at least one of the Rating Agencies at the time of purchase, including the subordinate classes of securities retained as part of the Company’s securitization of loans or purchases of 100% of the classes from other loan securitizations, and ARM loans held for securitization.

The Company maintains an allowance for loan losses based on management’s estimate of credit losses inherent in the Company’s portfolio of ARM Loans. The estimation of the allowance is based on a variety of factors including, but not limited to, current economic conditions, loan portfolio composition, delinquency trends, credit losses to date on underlying loans and remaining credit protection. If the credit performance of its ARM Loans is different than expected, the Company adjusts the allowance for loan losses to a level deemed appropriate by management to provide for estimated losses inherent in its ARM Loan portfolio. Additionally, once a loan 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 loan.

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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, securitized ARM loans and ARM loans collateralizing debt obligations are generally based on market prices provided by certain dealers who make markets in these financial instruments, or by third party pricing services. If the fair value of an ARM security or securitized ARM loan 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 on available market information.

The fair values of ARM loans held for securitization 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, interest rate, margin, length of fixed-rate period, life cap, periodic cap, underwriting standards, age and credit.

The net unrealized gain on commitments to purchase ARM loans from correspondent lenders and bulk sellers is calculated using the same methodologies that are used to value the Company’s ARM Loans, adjusted for anticipated fallout for interest rate lock commitments that will likely not be funded. The Company’s net unrealized gain (loss) on purchase loan commitments is recorded as a component of ARM loans, net on the Consolidated Balance Sheets with change in fair value recorded in Gain on ARM assets on the Consolidated Income Statements.

The fair values of the Company’s CDOs, senior unsecured notes (“Senior Notes”), interest rate swap agreements (“Swap Agreements”) and interest rate cap agreements (“Cap Agreements”) are based on market values provided by dealers who are familiar with the terms of the debt, Senior Notes, Swap Agreements and Cap Agreements.

The fair value of futures contracts is determined on a daily basis by the closing price on the Chicago Mercantile Exchange.

The fair values reported reflect estimates and may not necessarily be indicative of the amounts the Company could realize if these instruments were sold. Cash and cash equivalents, restricted cash, 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.

Hedging Instruments

All of the Company’s hedging instruments are derivative financial instruments (Cap Agreements, Swap Agreements and Eurodollar futures contracts) (collectively, “Hedging Instruments”) and are carried on the Consolidated Balance Sheets at their fair value as an asset, if their fair value is positive, or as a liability, if their fair value is negative. In general, most of the Company’s Hedging Instruments are designated as “cash flow hedges,” and the effective amount of change in the fair value of the derivative instrument is recorded in Accumulated other comprehensive income (loss) and transferred to earnings as the hedged item affects earnings. The ineffective amount of all Hedging Instruments is recognized in earnings each quarter. Generally, a hedging strategy is effective if it achieves offsetting cash flows attributable to the risk being hedged, but if the hedging strategy is not successful in achieving offsetting cash flows, it is ineffective. Certain Eurodollar futures contracts (“Eurodollar Transactions”) have not been designated as cash flow hedges since they are an economic hedge, hedging the fair value change of the Company’s purchase loan commitments. As such, the change in their fair value is recorded in the Consolidated Income Statements as Gain on ARM assets.

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. If it is determined that a hedge has been highly effective, but will not be prospectively, the Company discontinues hedge accounting prospectively.

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Hybrid Hedging Instruments

The Company enters into Swap Agreements, Eurodollar Transactions and Cap Agreements in order to manage its interest rate exposure when financing its Hybrid ARM assets (collectively, “Hybrid Hedging Instruments”). The Company generally borrows money based on short-term interest rates. The Company’s Hybrid ARM assets 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 Hybrid ARM assets. These Hybrid Hedging Instruments are used to fix the interest rate on the Company’s borrowings during the expected fixed-rate period of the Company’s Hybrid ARM assets such that the Company maintains a duration on the borrowings and Hybrid Hedging Instruments that closely matches the duration of the Company’s Hybrid ARM assets. The notional balances of the Hybrid Hedging Instruments generally decline over the life of these instruments approximating the declining balance of the Hybrid ARM assets being financed.

Swap Agreements and Eurodollar Transactions have the effect of converting the Company’s variable-rate debt into fixed-rate debt over the life of the Swap Agreements and Eurodollar Transactions. When the Company enters into a Swap Agreement, it agrees to pay a fixed rate of interest and to receive a variable interest rate, generally based on the London InterBank Offer Rate (“LIBOR”). The Company also enters into Eurodollar Transactions in order to fix the interest rate on its forecasted three-month LIBOR-based liabilities.

The Company also purchases Cap Agreements by incurring a one-time fee or premium. 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 contractually specified levels. Therefore, such Cap Agreements have the effect of capping the interest rate on a portion of the Company’s borrowings above a level specified by the Cap Agreement.

The Company designates its Hybrid Hedging Instruments used to manage interest rate exposure when financing its Hybrid ARM assets as cash flow hedges. All changes in the unrealized gains and losses on Hybrid Hedging Instruments have been recorded in Accumulated other comprehensive income (loss) and are reclassified to earnings as interest expense when each of the forecasted financing transactions occurs. If it becomes probable that the forecasted transaction, which in this case refers to interest payments to be made under the Company’s short-term borrowing agreements, will not occur by the end of the originally specified time period, as documented at the inception of the hedging relationship, or within an additional two-month time period thereafter, then the related gain or loss in Accumulated other comprehensive income (loss) would be reclassified to income. The carrying value of these Hybrid Hedging Instruments is included in Hedging instruments on the Consolidated Balance Sheets.

The unrealized gain/loss on Swap Agreements is based on 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 gain/loss in Accumulated other comprehensive income (loss) and the carrying value of the Swap Agreements adjust to zero and the Company realizes a fixed cost of money over the life of the Hedging Instrument.

Life Cap Hedging Instruments

The Company also purchases Cap Agreements to manage interest rate risk on the financing of a portion of its Traditional ARM assets that have a contractual maximum interest rate (“Life Cap”), which is a component of the fair value of an ARM asset (“Life Cap Hedging Instruments”).

The Company does not currently apply hedge accounting to its Life Cap Hedging Instruments and, as a result, the Company records the change in fair value of these Cap Agreements as hedging expense in current earnings. The carrying value of the Life Cap Hedging Instruments is included in Hedging instruments on the Consolidated Balance Sheets.

Pipeline Hedging Instruments

The Company enters into Eurodollar Transactions to manage interest rate risk associated with commitments to purchase ARM loans (“Pipeline Hedging Instruments”). The Company does not currently apply hedge accounting to

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its Pipeline Hedging Instruments and, therefore, the change in fair value and the realized gains (losses) on these Pipeline Hedging Instruments are recorded in current earnings. The net gain (loss) related to Pipeline Hedging Instruments is reflected in Gain on ARM assets on the Consolidated Income Statements as an offset to the net gain (loss) recorded for the change in fair value of the loan commitments recorded pursuant to SFAS 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities,” issued by the Financial Accounting Standards Board in April 2003.

Accumulated other comprehensive income (loss)

The Financial Accounting Standard Board’s Statement 130, “Reporting Comprehensive Income,” divides comprehensive income into net income and other comprehensive income (loss), which includes unrealized gains and losses on marketable securities defined as available-for-sale, and unrealized gains and losses on derivative financial instruments that qualify for hedge accounting under FAS 133.

The net unrealized gain on the Company’s ARM Loans of $92.5 million and $7.9 million at March 31, 2004 and December 31, 2003, respectively, is not included in Accumulated other comprehensive income (loss) because, in accordance with generally accepted accounting principles, the ARM Loans are carried at their amortized cost basis.

Income taxes

The Company elected to be taxed as a REIT and believes it complies with the provisions of the Internal Revenue Code of 1986, as amended (the “Code”) with respect thereto. Accordingly, the Company will not be subject to Federal income tax on that portion of its income that is distributed to shareholders, as long as certain asset, income and stock ownership tests are met.

Net earnings per share

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

Following is information about the computation of the EPS data for the three-month periods ended March 31, 2004 and 2003 (in thousands except per share data):

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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.

Note 2. Adjustable-Rate Mortgage Assets

The following tables present the Company’s ARM assets as of March 31, 2004 and December 31, 2003 (in thousands):

The Company recorded a net gain on ARM assets of $3.5 million during the quarter ended March 31, 2004. This gain consists of a $3.2 million gain on the sale of $345.5 million of ARM assets and a gain of $3.8 million on commitments to purchase loans from correspondent lenders and bulk sellers, partially offset by a net loss of $3.5 million on Eurodollar Transactions hedging the loan commitment pipeline. The Company did not realize any gain or loss on ARM assets during the quarter ended March 31, 2003.

During the quarter ended March 31, 2004, the Company securitized $1.1 billion of its ARM loans into a series of private-label multi-class ARM securities, all of which were placed with third party investors, thereby providing long-term collateralized financing for the Company’s assets, including over collateralization. The Company retained an interest-only subordinate certificate that provides credit support to the securitization. The Company did not account for this securitization as a sale and, therefore, did not record any gain or loss in

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connection with the securitization. As of March 31, 2004, the Company had $7.7 billion of ARM assets that have resulted from the Company’s securitization efforts.

The Company does not purchase mortgage servicing rights (“MSRs”), nor has the Company capitalized any MSRs in connection with any sale transaction. MSRs are capitalized upon the securitization of ARM loans as required by generally accepted accounting principles by allocating a portion of the cost basis of the securitized loans to the estimated value of the MSRs related to the loans retained by the Company as collateral in securitizations. The servicing spread, net of servicing costs and amortization, is recorded as Fee income on the Consolidated Income Statements, rather than being accounted for as interest income. MSRs capitalized upon the securitization of $1.1 billion of ARM loans during the quarter ended March 31, 2004 totaled $3.7 million. MSRs of $11.5 million, net of amortization during the quarter ended March 31, 2004 of $852.3 thousand, are included in Prepaid Expenses and Other on the Consolidated Balance Sheets at March 31, 2004. MSRs are carried at the lower of cost or fair value and are periodically evaluated for impairment using a discounted future cash flow model that considers portfolio characteristics and assumptions regarding prepayments speed, delinquency rates and other economic factors. For purposes of evaluating and measuring impairment of MSRs, the Company stratifies its portfolio on the basis of predominant risk characteristics, including loan type (Traditional ARM or Hybrid ARM). At March 31, 2004, the fair value of the MSRs in each risk stratum exceeded their cost basis. MSRs are amortized in proportion to, and over the expected period of, the estimated future net servicing income. Projected net servicing income is determined by the estimated future balance of the underlying mortgage loan portfolio, which declines over time from prepayments and scheduled loan amortization. The Company estimates future prepayment rates based on current interest rate levels, other economic conditions and market forecasts, as well as relevant characteristics of the servicing portfolio, such as loan types and recent prepayment experience.

As of March 31, 2004 and December 31, 2003, the Company had basis adjustments of $3.4 million on its ARM securities due to estimated credit losses (other than temporary declines in fair value) related to ARM securities purchased at a discount. As part of its purchase price, the Company recorded basis adjustments of $473.8 thousand related to ARM securities purchased during the first quarter of 2004 on which the Company had first loss credit exposure. These securities were purchased as part of $587.6 million of third party loan securitizations in which the Company purchased all classes of the securitizations, including the subordinated classes.

During the quarter ended March 31, 2004 the Company recorded loan loss provisions totaling $432.4 thousand to reserve for estimated credit losses on ARM Loans bringing its total loan loss reserve to $8.4 million.

The Company has credit exposure on its ARM Loans. The following tables summarize ARM Loan delinquency information as of March 31, 2004 and December 31, 2003 (in thousands, except for loan count):

     March 31, 2004

     December 31, 2003

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     As of March 31, 2004, the Company had commitments to purchase or originate the following amounts of ARM assets (in thousands):

The Company has entered into transactions whereby the Company expects to acquire the remaining balance of certain AAA-rated Hybrid ARM securities, at a price of par, between 2004 and 2008, when the fixed-rate period of the Hybrid ARM securities terminates and the securities convert into Traditional ARM securities with characteristics similar to the Traditional ARM securities held in the current portfolio. The Company views these transactions as an alternative source of Traditional ARM assets. The current balance of the Hybrid ARM securities is approximately $2.3 billion, but is expected to be less than 25% of that, and could be zero, at the time they convert into Traditional ARM securities. If the Company decides not to acquire the Hybrid ARM securities when they convert into Traditional ARM securities, then it is committed to pay or receive the difference between par and the fair value of the Traditional ARM securities at that time, as determined by an auction of the Traditional ARM securities. The Company received a premium of $2.3 million related to these transactions, which is being amortized over the declining balance of the related securities. As of March 31, 2004, the Company had delivered ARM assets with a carrying value of $6.7 million and $3.1 million in cash as collateral in connection with these transactions.

Note 3. Hedging Instruments

     Hybrid Hedging Instruments

As of March 31, 2004 and December 31, 2003, the Company was counterparty to Swap Agreements and Eurodollar Transactions having aggregate current notional balances of $14.4 billion and $12.5 billion, respectively. In addition, as of March 31, 2004, the Company had entered into two delayed Swap Agreements, one with a notional balance of $509 million becoming effective in April 2004, and the second with a notional balance of $180 million becoming effective in June 2004. As of March 31, 2004, these Swap Agreements and Eurodollar Transactions had a weighted average maturity of 3.6 years. In accordance with the Swap Agreements, the Company will pay a fixed rate of interest during the term of these Swap Agreements and receive a payment that varies monthly with the one-month LIBOR rate. As of March 31, 2004, ARM assets with a carrying value of $124.8 million, including accrued interest, and cash totaling $70.2 million collateralized the Swap Agreements and Eurodollar Transactions.

The net unrealized loss on Swap Agreements at March 31, 2004 of $186.3 million included Swap Agreements with gross unrealized gains of $2.7 million and gross unrealized losses of $189.0 million and is included in Hedging Instruments on the Consolidated Balance Sheets. As of December 31, 2003, the net unrealized loss of $85.5 million included Swap Agreements with gross unrealized gains of $14.9 million and gross unrealized losses of $100.4 million.

As of March 31, 2004, the net unrealized loss on Swap Agreements and deferred gains and losses on Eurodollar Transactions recorded in Accumulated other comprehensive income (loss) was a net loss of $199.8 million. The Company estimates that over the next twelve months, $87.3 million of these net unrealized losses will be reclassified from Accumulated other comprehensive income (loss) to interest expense.

As of March 31, 2004 and December 31, 2003, the Company’s Cap Agreements, used to manage its interest rate risk exposure on the financing of the Hybrid ARM loans collateralizing the Company’s CDOs, had remaining notional amounts of $1.4 billion and $1.6 billion, respectively. Included in these totals are Cap Agreements that have start dates ranging from 2006 to 2008 and notional balances totaling $371.1 million. The fair value of these Cap Agreements at March 31, 2004 and December 31, 2003 was $16.0 million and $25.4 million, respectively, and is included in Hedging instruments on the Consolidated Balance Sheets. As of March 31, 2004, the unrealized loss on these Cap Agreements of $15.7 million is included in Accumulated other comprehensive

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income (loss). In the twelve month period following March 31, 2004, $28.1 thousand of this unrealized loss is expected to be realized. Pursuant to the terms of these Cap Agreements, the notional amount of the Cap Agreements declines such that it is expected to equal the balance of the Hybrid ARM loans collateralizing the Company’s CDOs. Under these Cap Agreements, the Company will receive cash payments should the one-month LIBOR increase above the contract rates of these Hedging Instruments, which range from 3.25% to 9.67% and average 3.81%. The Cap Agreements had an average maturity of 4.9 years as of March 31, 2004 and will expire between 2006 and 2013.

The Company hedges the funding of its Hybrid ARM assets such that the weighted average net duration of borrowed funds, Hybrid Hedging Instruments and Hybrid ARM assets is less than one year. At March 31, 2004, the financing and hedging of the Company’s Hybrid ARM assets resulted in a net duration of approximately 1.3 months while the financing and hedging of all of the Company’s ARM assets resulted in a net duration of approximately 1.2 months.

Interest expense for the quarters ended March 31, 2004 and 2003 includes net payments on Hybrid Hedging Instruments of $61.5 million and $31.4 million, respectively.

     Life Cap Hedging Instruments

The Life Cap Hedging Instruments had no fair value at March 31, 2004, compared to a fair value of $9.0 thousand at December 31, 2003, and are included in Hedging instruments on the Consolidated Balance Sheets. Purchased Cap Agreements had a remaining notional amount of $838.1 million and $841.3 million as of March 31, 2004 and December 31, 2003, respectively. The notional amount of the Life Cap Hedging Instruments declines at a rate that is expected to approximate the amortization of the Traditional ARM assets. The Company will receive cash payments should the one-month or three-month LIBOR increase above the contract rates of these Hedging Instruments, which range from 6.00% to 12.00% and average 10.52%. The Life Cap Hedging Instruments had an average final maturity of 5 months as of March 31, 2004 and expire between 2004 and 2005. During the quarters ended March 31, 2004 and 2003, the Company recognized expenses of $158.1 thousand and $177.1 thousand, respectively, which is reported as Hedging expense in the Company’s Consolidated Income Statements.

     Pipeline Hedging Instruments

The fair value of the Pipeline Hedging Instruments at March 31, 2004 and December 31, 2003 was $4.3 million and $953.4 thousand, respectively, and is included in Hedging instruments on the Consolidated Balance Sheets. Pipeline Hedging Instruments had remaining notional balances of $374.0 million and $283.0 million at March 31, 2004 and December 31, 2003, respectively. During the quarter ended March 31, 2004, the Company recognized a $3.5 million loss on Pipeline Hedging Instruments, which is included in Gain on ARM assets in the Company’s Consolidated Income Statements and partially offsets the $3.8 million gain recorded on loan commitments pursuant to SFAS 149.

Note 4. Borrowings

     Reverse Repurchase Agreements

The Company has arrangements to enter into reverse repurchase agreements, a form of collateralized short-term borrowing, with 24 different financial institutions, and as of March 31, 2004, had borrowed funds from 18 of these firms. Because the Company borrows money under these agreements based on the fair value of its ARM assets, and because changes in interest rates can negatively impact the valuation of ARM assets, the Company’s borrowing ability under these agreements could be limited and lenders could initiate margin calls in the event interest rates change or the value of the Company’s ARM assets declines for other reasons.

As of March 31, 2004, the Company had $16.2 billion of reverse repurchase agreements outstanding with a weighted average borrowing rate of 1.18% and a weighted average remaining maturity of 3.4 months. As of December 31, 2003, the Company had $13.9 billion of reverse repurchase agreements outstanding with a weighted average borrowing rate of 1.25% and a weighted average remaining maturity of 4.9 months. As of

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March 31, 2004, $15.7 billion of the Company’s borrowings were variable-rate term reverse repurchase agreements with original maturities that range from three to twenty-five 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 $17.0 billion, including accrued interest, and cash totaling $34.2 million, collateralized the reverse repurchase agreements at March 31, 2004. Citigroup Inc. holds collateral with a fair value, in excess of reverse repurchase borrowings with a weighted average maturity of 4.6 months, of $198.4 million.

At March 31, 2004, the reverse repurchase agreements had the following remaining maturities (in thousands):

     CDOs

On March 31, 2004, $1.1 billion of ARM loans from the Company’s ARM loan portfolio were transferred to Thornburg Mortgage Securities Trust 2004-1 and were securitized. In this transaction, the Company issued AAA and AA-rated floating-rate pass-through certificates totaling $362.1 million and AAA and AA-rated fixed-rate pass-through certificates totaling $741.0 million to third party investors. The interest rates on the floating-rate pass-through certificates reset monthly and are indexed to the one-month LIBOR rate. The interest rates on the fixed-rate pass-through certificates are based on the weighted average pass-through rate of the pool of underlying Hybrid ARM loans which have initial fixed-rate terms ranging from three to ten years and then convert to Traditional ARM loans. In connection with the issuance of these CDOs, the Company incurred costs of $3.5 million, which were deducted from the proceeds of the transaction and are being amortized over the expected life of these CDOs. This transaction was accounted for as a financing of the loans and represents permanent financing that is not subject to margin calls. Based on the estimated exposure to credit losses on the loans collateralizing the debt, the structure of this transaction includes overcollateralization that provides $2.8 million of initial credit support and, if needed, additional credit support from excess cash flows over the life of a subordinate certificate retained by the Company.

All of the Company’s CDOs were issued by trusts and are secured by its ARM loans. For financial reporting and tax purposes, the trusts’ ARM loans held as collateral are recorded as assets of the Company and the CDOs are recorded as the Company’s debt. In some transactions, Hedging Instruments are held by the trusts and recorded as assets or liabilities of the Company. The Hedging Instruments either fix the interest rate of the pass-through certificates or cap the interest rate exposure on these transactions. As of March 31, 2004, the following CDOs were outstanding (in thousands):

	(1)		All-in interest rate includes the impact of issuance costs and Hedging Instruments.
	(2)		Includes financing hedged with Cap Agreements with a notional balance of $1.4 billion and a weighted average strike price of 3.81% as of March 31, 2004.

As of March 31, 2004, the CDOs were collateralized by ARM loans with a principal balance of $4.1 billion. The debt matures between 2033 and 2044 and is callable by the Company at par once the total balance of the

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loans collateralizing the debt is reduced to 20% of their original balance. The balance of this debt is reduced as the underlying loan collateral is paid down and is expected to have an average life of approximately four years.

     Whole Loan Financing Facilities

As of March 31, 2004, the Company had entered into four whole loan financing facilities. The interest rates on these facilities are indexed to one-month LIBOR and reprice accordingly. These facilities have a total committed borrowing capacity of $1.1 billion and an uncommitted capacity of $500 million and expire between September 2004 and March 2005. The Company expects to renew these facilities. As of March 31, 2004, the Company had $105.9 million borrowed against these whole loan financing facilities at an effective cost of 2.88%. As of December 31, 2003, the Company had $369.3 million borrowed against whole loan financing facilities at an effective cost of 2.32%. The amount borrowed on the whole loan financing facilities at March 31, 2004 was collateralized by ARM loans with a carrying value of $108.8 million, including accrued interest. These facilities have covenants that are standard for industry practice; the Company was in compliance with all such covenants at March 31, 2004.

One of the whole loan financing facilities discussed above (with a committed borrowing capacity of $300 million and maturing in March 2005,), 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.

     Senior Notes

On May 15, 2003, the Company issued $200.0 million in Senior Notes at par. On December 2, 2003, the Company completed an add-on private placement of $55.0 million of Senior Notes. The Senior Notes bear interest at 8.0%, payable each May 15 and November 15, and mature on May 15, 2013. The Senior Notes are redeemable at a declining premium, in whole or in part, beginning on May 15, 2008, and at par beginning on May 15, 2011. The Senior Notes may also be redeemed under limited circumstances on or before May 15, 2006. In connection with the issuance of the Senior Notes, the Company incurred costs of $4.5 million, which are being amortized to interest expense over the expected life of the Senior Notes. At March 31, 2004 and December 31, 2003, the balance of the Senior Notes outstanding, net of unamortized issuance costs, was $251.1 million.

As of March 31, 2004, all $255 million of the Senior Notes had been exchanged for new registered Senior Notes with terms substantially identical to the original Senior Notes, pursuant to exchange offers concluded by the Company.

The Company’s Senior Note obligations contain both financial and non-financial covenants. Significant financial covenants include limitations on the Company’s ability to incur indebtedness beyond specified levels, restrictions on the Company’s ability to incur liens on assets and limitations on the amount and type of restricted payments, such as repurchases of its own equity securities, that the Company makes. As of March 31, 2004, the Company was in compliance with all financial and non-financial covenants on its Senior Note obligations.

     Other

The total cash paid for interest was $120.3 million and $68.9 million for the quarters ended March 31, 2004 and 2003, respectively.

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     Contractual Obligations

As of March 31, 2004, the Company had the following contractual obligations (in thousands):

	(1)		Maturities of the Company’s CDOs are dependent upon cash flows received from the underlying loans receivable. The estimate of their repayment is based on scheduled principal payments on the underlying loans receivable. This estimate will differ from actual amounts to the extent prepayments and/or loan losses are experienced.
	(2)		The Consolidated Balance Sheets include a liability for Hedging Instruments with negative market values, which are not reflected in this table.

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 March 31, 2004 and December 31, 2003 (in thousands):

Note 6. Common Stock

On January 8, 2004, the Company filed a shelf registration statement on Form S-3 for $750 million of equity and debt securities. On January 21, 2004, the registration statement was declared effective by the Securities and Exchange Commission.

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During February 2004, the Company completed a public offering of 4,000,000 shares of common stock and received net proceeds of $110.1 million.

During the quarter ended March 31, 2004, the Company issued 698,400 shares of common stock through at-market transactions and received net proceeds of $19.6 million under controlled equity offering programs.

During the quarter ended March 31, 2004, the Company issued 1,351,706 shares of common stock under the Dividend Reinvestment and Stock Purchase Plan (the “DRSPP”) and received net proceeds of $38.7 million.

As of March 31, 2004, $630.8 million of the Company’s registered securities remained available for future issuance and sale under its shelf registration statement.

On December 16, 2003, the Company declared the fourth quarter 2003 dividend of $0.64 per share of common stock, which was paid on January 23, 2004 to shareholders of record as of December 31, 2003.

On April 20, 2004, the Company declared the first quarter 2004 dividend of $0.65 per share of common stock, which will be paid on May 17, 2004 to shareholders of record as of May 5, 2004.

For federal income tax purposes, all dividends are expected to be ordinary income to the Company’s common shareholders, subject to year-end allocations of the 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. Comprehensive Income (Loss)

Comprehensive income is composed of net income and other comprehensive income (loss), which includes the change in unrealized gains and losses on available-for-sale ARM securities and Hedging Instruments. The following table presents other comprehensive income (loss) (“OCI”) balances (in thousands):

The net unrealized gain on the Company’s ARM Loans of $92.5 million and $7.9 million at March 31, 2004 and December 31, 2003, respectively, is not included in Accumulated other comprehensive income (loss) because, in accordance with generally accepted accounting principles, the ARM Loans are carried at their amortized cost basis.

Note 8. Long-Term Incentive Awards

The Compensation Committee of the Company’s Board of Directors is authorized to grant Dividend Equivalent Rights (“DERs”), Stock Appreciation Rights (“SARs”) and Phantom Stock Rights (“PSRs”) pursuant to the Company’s Amended and Restated 2002 Long-Term Incentive Plan (the “Plan”), effective January 21, 2003.

As of March 31, 2004, there were 1,475,022 DERs outstanding, all of which were vested, and 731,855 PSRs outstanding, of which 538,478 were vested. The Company recorded an expense associated with DERs and

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PSRs of $4.5 million and $1.7 million for the quarters ended March 31, 2004 and 2003, respectively. Of the expense recorded in the first quarter of 2004, $1.4 million was the amount of dividend equivalents paid on DERs and PSRs, $585.2 thousand was the amortization of unvested PSRs and $2.5 million was the impact of the increase in the Company’s common stock price on the value of the PSRs which was recorded as a fair value adjustment. Of the expense recorded in the first quarter of 2003, $1.0 million was the amount of dividend equivalents paid on DERs and PSRs, $422.7 thousand was the amortization of unvested PSRs, and $210.0 thousand was the impact of the increase in the Company’s common stock price on the value of the PSRs which was recorded as a fair value adjustment.

Note 9. Transactions with Affiliates

The Company is managed externally by Thornburg Mortgage Advisory Corporation (“the Manager”) under the terms of a Management Agreement (the “Agreement”). During the quarters ended March 31, 2004 and 2003, the Company reimbursed the Manager $1.3 million and $1.1 million for expenses, respectively, in accordance with the terms of the Agreement. As of March 31, 2004 and 2003, $1.2 million and $850.0 thousand, respectively, was payable by the Company to the Manager for these reimbursable expenses.

For the quarters ended March 31, 2004 and 2003, the Company incurred costs of $3.6 million and $2.5 million, respectively, in base management fees in accordance with the terms of the Agreement. As of March 31, 2004 and 2003, $1.3 million and $872.1 thousand, respectively, was payable by the Company to the Manager for the base management fee.

For the three-month periods ended March 31, 2004 and 2003, the Manager earned performance-based compensation in the amount of $8.3 million and $6.2 million, respectively, in accordance with the terms of the Agreement. As of March 31, 2004 and 2003, $8.3 million and $6.2 million, respectively, was payable by the Company to the Manager for performance-based compensation.

As of March 31, 2004, the aggregate balance of mortgage loans outstanding to directors and officers of the Company, and to employees of the Manager and other affiliates, amounted to $33.2 million, had a weighted average interest rate of 3.61%, and maturities ranging between 2030 and 2034.

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Item 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Executive Overview

Our goal is to acquire or originate adjustable and variable rate mortgage (“ARM”) assets for our portfolio and manage them in such a way that we can create earnings and dividend stability in the near term and earnings and dividend growth in future periods. In order to achieve these objectives, we must mitigate key risks in the mortgage portfolio lending business and, simultaneously, pursue earnings growth strategies. Two of the principal risks in the mortgage lending business are credit risk and interest rate risk. Our three primary growth strategies are (i) to increase our higher margin, more profitable mortgage loan origination business; (ii) to raise new equity capital at a premium to book value in order to grow our assets and book value over time; and (iii) to better use our existing capital base by diversifying our funding sources, relying less on reverse repurchase agreements and more on long-term collateralized debt obligations (“CDOs”) to finance our balance sheet.

During the first quarter of 2004, our assets grew 17% from $19.1 billion at December 31, 2003 to $22.4 billion at March 31, 2004. Our net earnings increased 4% from $0.67 for the first quarter of 2003 to $0.70 per share for the first quarter of 2004. We raised $168.4 million of new equity capital during the quarter by issuing 6.1 million common shares at an average net price of $27.83 per share. Primarily as a result of raising this new common equity and the retention of earnings, our book value per common share rose 7% from $16.75 per share to $17.85 per share. Our book value growth outpaced our earnings growth because we experienced a margin decline during the quarter due to the costs associated with diversifying our funding sources and increasing our hedged position in order to better position ourselves for expected increases in interest rates.

Asset Growth and Channel Mix

Our ability to raise new equity capital at a premium to book value resulted in significant asset acquisition activity and growth during the quarter. We acquired $3.6 billion of ARM securities during the quarter, 99.7% of which were rated High Quality by at least one of either Standard & Poor’s Corporation or Moody’s Investors Service, Inc. (the “Rating Agencies”) (see page 28 for definition of High Quality). Also, as interest rates began to move upward during the prior quarter, our portfolio prepayment rate slowed to an average of 19% Constant Prepayment Rate (“CPR”) from 29% CPR in the previous quarter. We also continued to develop our “A” quality residential ARM loan origination business through approved correspondents and by directly originating ARM loans to retail customers. This source of ARM assets provided $908.9 million in new assets during the quarter, an increase of 5% from originations in the first quarter of 2003 of $864.1 million. We also acquired $89.0 million of loans through bulk acquisitions as compared to $341.4 million during the first quarter of 2003. As a result of these ARM loan originations and acquisitions, as of March 31, 2004, we owned $8.1 billion in ARM Loans (see page 27 for definition of ARM Loans), which amounted to 36% of our total assets.

According to the Mortgage Bankers Association (“MBA”), in 2003, mortgage originations industry-wide reached an unprecedented $3.8 trillion, a 53% increase over the $2.5 trillion originated in 2002. This record activity was primarily the result of low interest rates, which provided borrowers an opportunity to refinance their mortgage debt. As of April 14, 2004, the MBA is forecasting that overall residential loan originations for 2004 will decline 33% to $2.6 trillion based on an assumption that refinancing activity will decline by 53%, generally as a result of higher interest rates and the belief that most people who had an opportunity to refinance have done so. The same forecast also estimates that residential ARM loan origination will only decline 18% in 2004, since, generally speaking, in higher interest rate environments, ARM products become more attractive relative to 30-year fixed rate mortgage products. For the week ended April 23, 2004, the MBA reported that ARM loan originations accounted for 33% of total loan production versus 14% a year ago. We believe our traditional ARM products, which have interest rates that reprice in a year or less (“Traditional ARMs”), and hybrid ARM products, which have fixed interest rates for an initial period of three to ten years before converting to Traditional ARMs for their remaining terms to maturity (“Hybrid ARMs”) provide borrowers with more attractive financing options than fixed-rate mortgages and that we are well-positioned to benefit from borrowers’ increased participation in ARM loans. Based on first quarter loan production and a loan pipeline of $717.0 million at March 31, 2004, we believe we are on track to achieve our $3.7 billion origination target for 2004, which represents a decline of only 8% from our 2003 loan origination volume of $4.0 billion. We believe we can continue to outperform industry trends in the near term because, in addition to our already competitive mortgage interest rates, our focus on ARM loans and our innovative product menu, we now have completed the expansion of our lending approval to all 50 states and the District of Columbia. In addition, we continue to increase our network of approved and active correspondents, grow our internal sales force to help generate more loan production through

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correspondents, financial planners, corporate affinity groups and residential home builders, and have increased our marketing budget from $2.1 million in 2003 to $4.0 million in 2004. We want to grow the percentage of originated assets in our portfolio, because they have proven to be more profitable for us than purchased mortgage assets.

Funding Diversification

During the first quarter of 2004, we continued to diversify our funding sources by completing a CDO transaction in which we permanently financed $1.1 billion of ARM loans. In these CDO transactions, we issue mortgage-backed securities (“MBS”) to third party investors. We do not account for any of our ARM loan securitizations as sales. These securities receive principal and interest payments from the ARM loans placed in a trust, and these financings have no further recourse to us. Consistent with our matched funding policy, $741.0 million of the CDOs issued in the first quarter are fixed-rate debt with terms that match the initial fixed-rate terms of the underlying pool of Hybrid ARM Loans financed by this transaction. Unlike reverse repurchase agreement borrowings that are subject to margin calls based on the change in fair value of the collateral or changes in margin requirements, CDOs are not subject to any margin calls. A typical reverse repurchase agreement borrowing requires 4% to 5% of initial capital plus an additional capital reserve in order to meet any margin calls. As a result, we have developed a policy to maintain no less than 8% of capital against our assets financed with recourse debt, which includes a combination of our reverse repurchase agreement borrowings and our whole loan financing lines. To the extent we have been able to fund a portion of our balance sheet with CDOs, we have reduced our capital requirement and can utilize freed up capital to acquire additional ARM assets. As of March 31, 2004, the $4.1 billion of CDO financing outstanding required approximately 2% of equity capital, freeing up approximately $302 million of capital for the acquisition of approximately $2.1 billion of additional ARM assets. CDOs accounted for 20% of our borrowings as of March 31, 2004.

Credit Quality

We acquire excellent credit quality ARM assets and securitize the ARM loans we either originate or acquire. These strategies create significant portfolio liquidity and allow us to easily finance our portfolio. As of March 31, 2004, 97.2% of our ARM asset portfolio was High Quality as compared to 96.3% as of December 31, 2003. Many of our High Quality ARM assets consist of ARM Loans that we have either securitized for our own portfolio or have placed in a trust to facilitate our CDO financings. We retain the risk of potential credit losses on these loans. We did not experience any credit losses on ARM Loans during the first quarter of 2004 and have only experienced $173.9 thousand in credit losses since we began acquiring ARM loans in 1997. Although we believe our credit performance is reflective of the high credit quality of our borrowers, our prudent underwriting, and property appraisal methods and policies, we also recognize that our ARM Loan portfolio was, on average, only approximately 14 months old. Due to this lack of seasoning and, therefore, lack of relevant historical data, we have recorded a loan loss allowance of $8.4 million as of March 31, 2004 based on management’s expectations given industry loss experience on similar loans.

Interest Rate Risk Management

We use interest rate swap agreements (“Swap Agreements”), interest rate cap agreements (“Cap Agreements”) and Eurodollar futures contracts (“Eurodollar Transactions”) (collectively, “Hybrid Hedging Instruments”), as hedges to fix, or cap, the interest rates on our short-term borrowings and on our CDOs. We continue our strategy of hedging our financing cost such that we maintain a net duration of our Hybrid ARM assets, related borrowings and Hybrid Hedging Instruments of less than one year. The lower the duration gap, the less impact interest rate changes will have on earnings. As of March 31, 2004, we had entered into Swap Agreements and Eurodollar Transactions with a current notional balance of $14.4 billion and delayed Swap Agreements with notional balances totaling $689 million that become effective in the second quarter of 2004. Additionally, we had Cap Agreements with a current notional balance of $2.2 billion. As a result, as of March 31, 2004, we measured the net duration applicable to our Hybrid ARM portfolio, related borrowings and Hybrid Hedging Instruments at approximately 1.3 months while the financing and hedging of all of the Company’s ARM assets resulted in a net duration of approximately 1.2 months. Although we experienced a declining interest rate environment from 2001 to 2003, we continue to employ a matched funding strategy as we acquire Hybrid ARM assets in order to ensure stable earnings during periods of rising interest rates. In essence, as we acquire ARM assets, we attempt to “lock-in” a spread that is expected to provide a rate of return at or above our threshold requirement. In order to stabilize the spread over the expected life of our ARM assets, we use hedging instruments in conjunction with our borrowings to approximate the repricing characteristics of our ARM assets. Given the prepayment uncertainties of our ARM assets, there is no sure way to “lock-in” a spread between the yield on our ARM assets and the related borrowing. However, through active management, we believe we can continue to mitigate a significant amount of net interest income volatility. See a discussion of Effects of Interest Rate Changes on page 50.

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Consistent Profitability

We possess a number of strategic advantages that allow us to generate consistent profitability. One of these strategic advantages is our low operating expense structure. During the first quarter of 2004, our operating expenses as a percent of average assets were 0.40%, compared to 0.47% for the same quarter of 2003 and 0.38% during the fourth quarter of 2003. We are able to operate at this low level of operating expenses relative to the size of our portfolio because we do not operate like a traditional mortgage lender. We acquire many of our assets through MBS purchases and originate loans by developing strategic partnerships with correspondent lenders, financial planners and other intermediaries. We also use web-based marketing and a third party call center and we do not have a retail branch network or commissioned loan officers. We also do not acquire loans through mortgage brokers. In addition, we have developed other strategic partnerships that provide outsourced services on a variable cost basis to our customers in the name of Thornburg Mortgage. We believe that this low, variable-cost model has allowed us to operate profitably with a lower interest rate spread on our portfolio, enabling us to mitigate significant risks normally associated with mortgage origination and portfolio lending activities. One of the strategic decisions we have been able to make as a result of our low-cost operating model is to invest primarily in Agency, AAA, AA or “A” quality ARM loans. This strategy has resulted in very low credit losses, a very liquid and readily financeable portfolio, and a portfolio that has had low price volatility as compared to a portfolio of 30-year, fixed-rate mortgage assets. Additionally, we have been able to mitigate interest rate risk by entering into hedging transactions and still achieve acceptable returns for our shareholders. Finally, by employing a portfolio lending strategy, we do not depend on gain on sale income, which can fluctuate significantly with loan origination volume.

The increase in our earnings in the first quarter of 2004 compared to the comparable quarter of 2003 and the fourth quarter of 2003 can be attributed to a number of factors, including selling additional shares of common stock at a premium to book value and increasing our use of capital relative to the amount of common equity outstanding through the use of CDOs as discussed above, as well as the Senior Notes issued during 2003. Although we experienced a decline in our portfolio margin from 1.47% for the fourth quarter of 2003, to 1.40% during the current quarter, we generated a 4% increase in net interest income due to our capital growth. This capital growth led to an expansion of our balance sheet, and our ability to more efficiently use shareholders’ equity. The decline in our net interest spread is partially the result of additional hedging costs as we position ourselves for expected increases in interest rates. See further discussion of the change in our interest rate spreads in “Results of Operations For the Three Months Ended March 31, 2004,” beginning on page 43.

Forward-Looking Statements

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, that are based on our current expectations, estimates and projections. Pursuant to those sections, we may obtain a “safe harbor” for forward-looking statements by identifying those statements and by accompanying those statements with cautionary statements, which identify factors that could cause actual results to differ from those expressed in the forward-looking statements. Statements that are not historical facts, including statements about our beliefs and expectations, are forward-looking statements. The words “believe,” “anticipate,” “intend,” “aim,” “expect,” “will,” “strive,” “target” and “project” and similar words identify forward-looking statements. Such statements are not guarantees of future performance, events or results and involve potential risks and uncertainties. Accordingly, our actual results may differ from our current expectations, estimates and projections. Important factors that may impact our actual results or may cause our actual results to differ materially from those expressed in any forward-looking statements made by us or on our behalf include, but are not limited to, changes in interest rates, changes in yields available for purchase on adjustable and variable rate mortgage assets, changes in the yield curve, changes in prepayment rates, changes in the supply of MBS and loans, our ability to obtain financing and the terms of any financing that we do obtain. We do not undertake, and specifically disclaim, any obligation to publicly release the result of any revisions that may be made to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements.

Corporate Governance

We pride ourselves on maintaining an ethical workplace in which the highest standards of professional conduct are practiced. Accordingly, we would like to highlight the following facts relating to corporate governance:

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	•		Our Board of Directors is, and has always been, composed of a majority of independent directors. The Audit, Nominating/Corporate Governance and Compensation Committees of the Board of Directors are, and always have been, composed exclusively of independent directors.
	•		We have a Code of Business Conduct and Ethics and Corporate Governance Guidelines that cover a wide range of business practices and procedures that apply to all of our employees, officers and directors and of the Manager that foster the highest standards of ethics and conduct in all of our business relationships.
	•		We have an Insider Trading Policy that prohibits any of the directors or officers of the Company or any director, officer or employee of the Manager from buying or selling our stock on the basis of material nonpublic information, and prohibits communicating material nonpublic information to others.
	•		We are managed externally by Thornburg Mortgage Advisory Corporation (the “Manager”) under the terms of a management agreement (the “Management Agreement”), subject to the supervision of our Board of Directors. The Manager’s compensation is based on formulas tied to our success in increasing common equity capitalization and generating net income above defined targets. The Compensation Committee and the independent directors annually evaluate the Manager’s performance and determine whether the compensation paid to the Manager is reasonable in relation to the nature and quality of services performed.
	•		We have a formal internal audit function to further the effective functioning of our internal controls and procedures. Our internal audit plan is based on a formal risk assessment and is intended to provide management and the Audit Committee with an effective tool to identify and address areas of financial or operational concerns and ensure that appropriate controls and procedures are in place. We are currently implementing Section 404 of the Sarbanes-Oxley Act of 2002, which requires an evaluation of internal control over financial reporting in association with our financial statements for the year ending December 31, 2004.

Our Internet website address is www.thornburgmortgage.com. We make available free of charge, through our Internet website, our annual report on Form 10-K, our quarterly reports on Form 10-Q, our current reports on Form 8-K and any amendments to those reports that we file or furnish pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission (the “SEC”).

You may also find our Code of Business Conduct and Ethics, Corporate Governance Guidelines and the charters of the Audit Committee, Nominating/Corporate Governance Committee and Compensation Committee of our Board of Directors at our website. These documents are also available in print to anyone who requests them by writing to us at the following address: 150 Washington Avenue, Suite 302, Santa Fe, New Mexico, 87501, or by phoning us at (505) 989-1900.

Please note that the reference to our website address is an inactive textual reference made only for purposes of complying with SEC rules.

Critical Accounting Policies and Estimates

Our financial statements are prepared in conformity with generally accepted accounting principles, many of which require the use of estimates and assumptions. In accordance with recent SEC guidance, those material accounting policies and estimates that we believe are the most critical to an investor’s understanding of our financial results and condition and require complex management judgment are discussed below.

•

Fair Value. We record our ARM securities, commitments to purchase ARM loans and Hybrid Hedging Instruments at fair value. The fair values of our ARM securities and Hybrid Hedging Instruments 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, Hybrid Hedging Instrument or other financial instrument is not reasonably available from a dealer or a third party pricing service, management estimates the fair value. This requires management judgment in determining how the market would value a particular ARM security, Hybrid Hedging Instrument or other financial instrument, based on characteristics of the security we receive from the issuer and available market information. The net unrealized gain or loss on loans expected to be purchased from correspondent lenders and bulk sellers is calculated using the same methodologies that are used to value our ARM Loans, adjusted for anticipated fallout for interest rate lock

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commitments that will likely not be funded. The fair values reported reflect estimates and may not necessarily be indicative of the amounts we could realize in a current market exchange.

•		Loan Loss Reserves on ARM Loans. We maintain an allowance for loan losses based on management’s estimate of credit losses inherent in our portfolio of ARM Loans. The estimation of the allowance is based on a variety of factors including, but not limited to, current economic conditions, loan portfolio composition, delinquency trends, credit losses to date on underlying loans and remaining credit protection. If the credit performance of our ARM Loans is different than expected, we adjust the allowance for loan losses to a level deemed appropriate by management to provide for estimated losses inherent in our ARM Loan portfolio. Two critical assumptions used in estimating the loan loss reserves are an assumed rate of default, which is the expected rate at which loans go into foreclosure over the life of the loans, and an assumed rate of loss severity, which represents the expected rate of realized loss upon disposition of the properties that have gone into foreclosure.
		The following table presents a sensitivity analysis to show the impact on our allowance for loan loss reserves of using different assumptions (in thousands):

The purpose of this analysis is to provide an indication of the impact defaults and loss severity assumptions have on our estimate of the allowance for loan losses. It is not intended to imply our expectation of future default levels or changes in loss severity. We believe the current assumptions used for defaults and loss severity are appropriate.

•		Basis Adjustments on ARM securities. Basis adjustments are a designated component of the purchase discount on our ARM securities. Certain of our ARM securities are rated less than Investment Grade and represent subordinated interests in high-quality, first lien residential mortgage loans where we own all of the securitized classes. We generally purchase the less than Investment Grade classes at a discount. Based upon management’s use of analytical tools and judgment, a portion of the purchase discount is subsequently accreted as interest income under the effective yield method while the remaining portion of the purchase discount is treated as a basis adjustment which reflects the estimated unrealized loss on the securities due to credit loss and interest rate exposure. Basis adjustments are increased by recognizing an impairment loss when management determines that there is a decline in the fair value of an ARM security that is considered other than temporary and decreased when there is improvement in the risk exposures. Any such determinations are based on management’s assessment of numerous factors affecting the fair value of ARM securities, including, but not limited to, current economic conditions, delinquency trends, credit losses to date on underlying mortgages and remaining credit protection. If management ultimately concludes that the basis adjustments will not represent realized losses, the balances are accreted into earnings over the remaining life of the security.
•		Revenue Recognition. Interest income on ARM assets is a combination of accruing interest based on the outstanding balance and contractual terms of the assets and the amortization of yield adjustments using generally accepted interest methods, principally the amortization of purchase premiums and discounts. Premiums and discounts associated with the purchase of 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. Estimating prepayments and estimating the remaining lives of our ARM assets requires management judgment, which involves consideration of possible future interest rate environments and an estimate of how borrowers will behave in those environments. The actual lives could be more or less than the amount estimated by management at the time of purchase of the ARM assets.

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

General

We are a single-family residential mortgage lender that originates, acquires and retains investments in ARM assets, thereby providing capital to the single-family residential housing market. Our ARM assets are comprised of Traditional ARM and

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Hybrid ARM securities and loans. ARM securities represent interests in pools of ARM loans, which are publicly rated and include guarantees or other third party credit enhancements against losses from loan defaults. “ARM Loans” consist of securitized ARM loans, ARM loans collateralizing long-term debt and ARM loans held for securitization. Like traditional banking institutions, our income is generated primarily from the net spread or difference between the interest income we earn on our ARM assets and the cost of our borrowings. Our strategy is to maximize the long-term sustainable difference between the yield on our investments and the cost of financing these assets, and to maintain that difference through interest rate and credit cycles.

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 finance the purchases and originations of our ARM assets with equity capital, unsecured debt, short-term borrowings such as reverse repurchase agreements, whole loan financing facilities, CDOs and other collateralized financings that we may establish with approved institutional lenders. When we borrow short-term or floating-rate funds to finance our Hybrid ARM assets, we also enter into interest rate hedging transactions, which fix our borrowing costs during the fixed-rate period of the Hybrid ARM asset. We have a policy to operate with an “Adjusted Equity-to-Assets Ratio”, a non-GAAP measurement, of at least 8% and we typically operate with a 9 to 10% Adjusted Equity-to-Assets Ratio. (See “Capital Utilization” on page 40 for a calculation of our Adjusted Equity-to-Assets Ratio.) Since all of the assets we hold are ARM assets and we pursue a matched funding strategy, we believe our exposure to changes in interest rates can be prudently managed. Moreover, we focus on acquiring primarily high quality assets to ensure our access to financing. Similarly, we maintain strict credit underwriting standards and have experienced cumulative credit losses of only $173.9 thousand on our loan portfolio since we began acquiring loans in 1997. Our low cost operating structure has resulted in operating costs well below those of other mortgage originators. We believe 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, pay substantially all of our earnings in the form of dividends to shareholders, without paying federal or state income tax at the corporate level.

Portfolio Strategies

Our business strategy is to acquire and originate ARM assets to hold in our portfolio, fund them using equity capital and borrowed funds, and generate earnings from the difference, or spread, between the yield on our assets and our cost of borrowing.

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

We originate ARM loans for our portfolio through our correspondent lending program, which currently includes approximately 145 approved and active correspondents, and we originate loans direct to consumers through our wholly owned mortgage loan origination subsidiary, Thornburg Mortgage Home Loans, Inc. (“TMHL”). Currently, TMHL is authorized to lend in all 50 states and the District of Columbia. We believe that diversifying our sources for ARM Loans and ARM securities will enable us to consistently find attractive opportunities to acquire or create high quality assets at attractive yields and spreads for our portfolio.

We have a focused portfolio lending investment policy designed to minimize credit risk and interest rate risk. Our mortgage assets portfolio may consist of ARM securities guaranteed by an agency of the federal government (“Ginnie Mae”) or a government-sponsored corporation or federally-chartered corporation (“Fannie Mae” or “Freddie Mac”) (collectively, “Agency Securities”), or privately issued (generally publicly registered) ARM pass-through securities, multi-class pass-through securities, floating-rate classes of collateralized mortgage obligations (“CMOs”), “A” or prime quality ARM loans that we intend to securitize, securities issued by others where we have purchased all of the resulting classes, fixed-rate MBS with an expected duration of one year or less or other short-term investments that either mature within one year or have an interest rate that reprices within one year.

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Our investment policy requires that we invest at least 70% of total assets in High Quality ARM assets and short-term investments. High Quality means:

	(1)		Agency Securities; or
	(2)		ARM securities and securitized ARM loans which are rated within one of the two highest rating categories by at least one of the Rating Agencies; or
	(3)		securities and securitized loans that are unrated or whose ratings have not been updated but are determined to be of comparable quality (by the rating standards of at least one of the Rating Agencies) to a High Quality rated mortgage security, as determined by the Manager and approved by our Board of Directors; or
	(4)		the portion of ARM 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 that 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; or
	(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 our loan acquisition and securitization efforts or are acquired as part of a loan securitization effected by third parties in which we purchase all of the classes of the loan securitization, and that equal an amount no greater than 17.5% of shareholders’ equity, measured on a historical cost basis.

Our ARM assets include investments in Hybrid ARM assets, which are typically 30-year loans with 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 ARM assets with fixed-rate periods of greater than five years to no more than 20% of our total assets. We also have a policy to maintain a net duration, or duration gap, of one year or less on our Hybrid ARM assets (including commitments to purchase Hybrid ARM assets), related borrowings and Hybrid Hedging Instruments. We use Hybrid Hedging Instruments, as hedges to fix, or cap, the interest rates on our short-term borrowings and on our CDOs.

To mitigate the adverse effect of an increase in prepayments on our ARM assets, we emphasize the purchase of ARM assets at prices close to or below par. We amortize any premiums paid for our assets over their expected lives using the effective yield method of accounting. To the extent that the prepayment rate on our ARM assets differs from expectations, our net interest income will be affected. Prepayments generally increase when mortgage interest rates fall below the interest rates on ARM loans. To the extent there is an increase in prepayment rates, resulting in a shortening of the expected lives of our ARM assets, our net income and, therefore, the amount available for dividends could be adversely affected.

We believe that our status as a mortgage REIT makes an investment in our equity securities attractive for tax-exempt investors, such as pension plans, profit sharing plans, 401(k) plans, Keogh plans and Individual Retirement Accounts. We do not invest in real estate mortgage investment conduit (“REMIC”) residuals or other CMO residuals that would result in the creation of excess inclusion income or unrelated business taxable income.

Acquisition, Securitization and Retention of Traditional ARM and Hybrid ARM Loans

We acquire and originate “A” quality mortgage loans through TMHL from three sources: (i) correspondent lending, (ii) direct retail loan originations, and (iii) bulk acquisitions. Correspondent lending involves acquiring individual loans from correspondent lenders whom we have approved and who originate the individual loans using our product pricing, underwriting criteria and guidelines, or criteria and guidelines that we have approved. Direct retail loan originations are loans that we originate through intermediaries such as financial advisors, corporate affinity clients and home builders or directly to consumers via the Internet or by telephone. Bulk acquisitions involve acquiring pools of whole loans, which are originated

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using the seller’s guidelines and underwriting criteria. The loans we acquire or originate are financed through warehouse borrowing arrangements pending securitization for our portfolio.

The loans acquired or originated by TMHL are first lien, single-family residential Traditional ARM and Hybrid ARM loans with original terms to maturity of not more than forty years and are either fully amortizing or are interest-only up to ten years, and fully amortizing thereafter.

All ARM loans that we acquire or originate for our portfolio bear an interest rate tied to an interest rate index. Most loans have periodic and lifetime constraints on how much the loan interest rate can change on any predetermined interest rate reset date. The interest rate on each Traditional ARM loan resets monthly, semi-annually or annually. The Traditional ARM loans generally adjust to a margin over a U.S. Treasury index or a LIBOR index. The Hybrid ARM loans have a fixed rate for an initial period, generally 3 to 10 years, and then convert to Traditional ARM loans for their remaining term to maturity.

We acquire ARM loans for our portfolio with the intention of securitizing them into pools of High Quality ARM securities and retaining them in our portfolio as securitized ARM loans. Alternatively, we may also use our loans as collateral for CDOs. In order to facilitate the securitization or financing of our loans, we generally create subordinate certificates, which provide a specified amount of credit enhancement. Upon securitization, we generally retain the securities issued, including the subordinate certificates, and either finance them in the repurchase agreement market or through the issuance of CDOs in the capital markets. Our investment policy limits the amount we may retain of these below Investment Grade subordinate certificates, and subordinate classes that we purchase in connection with a whole pool securitization effected by third parties, to 17.5% of shareholders’ equity, measured on a historical cost basis.

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

We offer a loan modification program on all loans we originate and certain loans we acquire. We believe this program promotes customer retention and reduces loan prepayments. Under the terms of this program, a borrower pays a fee to modify the mortgage loan to any then-available Hybrid or Traditional ARM product that we offer at the offered retail interest rate plus 1/8%. During the first quarter of 2004, we modified 142 loans with balances totaling $71.5 million. At April 13, 2004, the pipeline of loans to be modified totaled $173.6 million which represents a significant increase in mortgage loan modification activity compared to the fourth quarter of 2003 due to volatility in interest rates.

Financing Strategies

We finance our ARM assets using equity capital, unsecured debt, short-term borrowings such as reverse repurchase agreements, whole loan financing facilities, CDOs, and other collateralized financings that we may establish with approved institutional lenders. See “Hedging Strategies” below for a discussion of how we convert short-term borrowings into long-term fixed-rate financing for purposes of managing our interest rate risk. We have established lines of credit and collateralized financing agreements with 24 different financial institutions. Reverse repurchase agreements involve a simultaneous sale of pledged assets to a lender at an agreed-upon price in return for the lender’s agreement to resell the same assets back to us at a future date (the maturity of the borrowing) at a higher price. The price difference is the cost of borrowing under these agreements. Because we borrow money under these agreements based on the fair value of our ARM assets, our borrowing ability under these agreements could be limited and lenders could initiate margin calls in the event of interest rate changes or if the value of our ARM assets declines for other reasons.

We generally enter into two types of reverse repurchase agreements: variable rate term reverse repurchase agreements and fixed-rate reverse repurchase agreements. Our variable rate term reverse repurchase agreements are financings with original maturities ranging from three to twenty-five months. The interest rates on these variable rate term reverse repurchase agreements are generally indexed to either the one-month or three-month LIBOR rate, and reprice accordingly. The fixed-rate reverse repurchase agreements have original maturities generally ranging from 30 to 180 days. Generally, upon repayment of each reverse repurchase agreement, we immediately pledge the ARM assets used to collateralize the financing to secure a new reverse repurchase agreement.

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We have also financed the purchase of ARM assets by issuing floating-rate and fixed-rate CDOs in the capital markets, which are collateralized by ARM loans that are placed in a trust. The trust pays the principal and interest payments on the debt out of the cash flows received on the collateral. This structure enables us to make more efficient use of our capital because the capital requirement to support these financings is less than the amount required to support the same amount of financings in the reverse repurchase agreement market. These transactions are a permanent form of financing and are not subject to margin calls.

We also have financing facilities, or credit lines, for whole loans. A whole loan is the actual mortgage loan evidenced by a note and secured by a mortgage or deed of trust. We use these whole loan financing facilities to finance our acquisition of whole loans while we are accumulating loans for securitization.

We have issued senior unsecured notes (“Senior Notes”) in the amount of $255 million. The Senior Notes bear interest at 8.0%, payable each May 15 and November 15, and mature on May 15, 2013. The Senior Notes are redeemable at a declining premium, in whole or in part, beginning on May 15, 2008, and at par beginning on May 15, 2011. The Senior Notes may also be redeemed under limited circumstances on or before May 15, 2006.

Capital Utilization

Our Board has approved a policy that limits our capacity to borrow funds to finance mortgage assets based on our equity capital and unsecured debt. We monitor the relationship between our assets, borrowings and equity capital using a variety of different measures. The primary operating policy that limits our borrowings and leverage is a requirement to maintain our Adjusted Equity-to-Assets Ratio, a non-GAAP measurement, at a minimum of 8%. Our Adjusted Equity-to-Assets Ratio represents the long-term capital (both equity and Senior Notes) supporting our recourse or marginable debt. Recourse or marginable debt generally consists of reverse repurchase agreements and whole loan financing facilities. These forms of borrowing are short-term in nature, mature on a frequent basis (weighted average maturity of 3.4 months as of March 31, 2004), need to be rolled over at each maturity and are subject to margin call based on collateral value changes or changes in margin requirements. Because of the short-term nature of these forms of financing, our policy requires that we maintain significant excess capital and liquidity to meet margin calls as a result of unexpected changes in margin requirements and collateral value. Our policy is to maintain a capital cushion equal to approximately twice the margin requirement when using these forms of borrowings. Our margin requirements typically range between 4% and 5% for these borrowings, so our policy requires that we maintain capital of at least 8%, and typically 9% to 10%, against the financing of these assets. This capital cushion has proved to be more than adequate to support our borrowing arrangements through a variety of interest rate and credit cycles.

As we replace our reverse repurchase agreement borrowings with CDO financings, the risk of margin calls, changes in margin requirements and potential rollover risk is eliminated because CDO financings represent permanent, non-recourse financing whose terms are established at the time of the financing and are not subject to change. As a result, the need to maintain a capital cushion comparable to what we maintain on our recourse borrowings is eliminated. For purposes of maintaining an adequate capital cushion, our policy allows us to eliminate all assets (and the associated equity capital) associated with CDO financing from our operating capital ratio. Additionally, we eliminate from our Adjusted Equity-to-Assets Ratio any unrealized market value adjustments, recorded in Accumulated other comprehensive income (loss), from our equity accounts, and we include our Senior Notes as an additional form of long-term capital as if the notes were equity capital. (See calculation of the Adjusted Equity-to-Assets Ratio on page 41.) Because the CDOs only require approximately 2% of equity capital to support the CDO financing, versus the 8% to 10% policy requirement on our recourse borrowings, we are able to use this freed-up capital to acquire additional assets. We expect that we will be able to retain and carry an increased amount of assets in the future as a percentage of our equity capital base.

Hedging Strategies

We attempt to mitigate our interest rate risk by funding our ARM assets with borrowings and hedging instruments whose combined maturities approximately match the interest rate adjustment periods on our ARM assets. Therefore, some of our borrowings bear variable or short-term (one year or less) fixed interest rates because a portion of our ARM assets, the Traditional ARMs, have interest rates that adjust within one year. However, we finance our Hybrid ARM portfolio with borrowings hedged with Swap Agreements, Eurodollar Transactions and Cap Agreements that fix the interest rate on the borrowings such that the net duration of the Hybrid ARM portfolio, the related borrowings and the associated Hybrid Hedging Instruments is one year or less. A lower duration indicates a lower expected volatility of earnings given future

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changes in interest rates. When we enter into a Swap Agreement, we agree to pay a fixed rate of interest and to receive a variable interest rate, generally based on LIBOR. We also enter into Eurodollar Transactions in order to fix the interest rate changes on our forecasted three-month LIBOR-based liabilities. Each Eurodollar futures contract is a three-month contract with a price that represents the forecasted three-month LIBOR rate. Selling Eurodollar futures contracts locks in a future interest rate. The difference between these two values results in a gain or loss that offsets the change in the three-month LIBOR rate and “locks-in” the forecasted three-month LIBOR rate for financing purposes. We purchase Cap Agreements by incurring a one-time fee or premium. Pursuant to the terms of the Cap Agreements, we will receive cash payments if the interest rate index specified in any such Cap Agreement increases above contractually specified levels. Therefore, such Cap Agreements have the effect of capping the interest rate on a portion of our borrowings above a level specified by the Cap Agreement. The notional balances of the Hybrid Hedging Instruments generally decline over the life of these instruments. As of March 31, 2004, our Hybrid Hedging Instruments had a remaining average term to maturity of 3.7 years before considering the effects of prepayments and when combined with our Hybrid ARM assets and related borrowings had a net duration of approximately 1.3 months, including the effects of prepayments.

In general, our Traditional ARM assets 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 have also entered into Cap Agreements, so that the net margin on our Traditional ARM assets with maximum lifetime interest rate caps will be protected in high interest rate environments. These Cap Agreements are referred to as “Life Cap Hedging Instruments.” Pursuant to the terms of these Life Cap Hedging Instruments owned as of March 31, 2004, we will receive cash payments if the applicable index, generally the three-month or six-month LIBOR index, increases above contractually specified levels. The fair value of these Cap Agreements generally increases when general market interest rates increase and decreases when market interest rates decrease, helping to partially offset changes in the fair value of our ARM assets related to the effect of the lifetime interest rate cap. We are not currently purchasing Life Cap Hedging Instruments because current interest rates are significantly lower than the contractual life caps on our ARM assets.

In addition, some Traditional ARM assets are 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 1.00% per semiannual adjustment or 2.00% per annual adjustment. The borrowings that we incur do not have similar periodic caps. However, we believe the impact of the periodic caps is somewhat mitigated because we own our ARM assets at a net price above par and, therefore, the yield on our ARM assets can change by an amount greater than the associated periodic cap due to changes in the amortization of the net price above par. Further, 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. As of March 31, 2004, $2.6 billion of our Traditional ARM assets have periodic caps, representing 12.0% of total ARM assets.

We also enter into Eurodollar Transactions to manage interest rate risk associated with commitments to purchase ARM loans (“Pipeline Hedging Instruments.”) The gain (loss) on the Pipeline Hedging Instruments offsets the gain (loss) recorded for the change in fair value of the loan commitments.

We may enter into other hedging-type transactions designed to protect our borrowing costs or portfolio yields from interest rate changes. We may also purchase “interest-only” mortgage derivative assets or other mortgage derivative products for purposes of mitigating risk from interest rate changes, although we have not, to date, entered into these types of transactions. We may also use, from time to time, futures contracts and options on futures contracts on the Eurodollar, Federal Funds, Treasury bills and Treasury notes and similar financial instruments to mitigate risk from changing interest rates.

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

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Financial Condition

     Asset Quality

At March 31, 2004, we held total assets of $22.4 billion, $21.9 billion of which consisted of ARM assets. That compares to $19.1 billion in total assets and $18.9 billion of ARM assets at December 31, 2003. Since commencing operations, we have purchased either ARM securities (backed by Agency Securities or privately-issued MBS) or ARM loans generally originated to “A” quality underwriting standards. At March 31, 2004, 97.1% of the assets 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.

The following tables present schedules of ARM assets owned at March 31, 2004 and December 31, 2003 classified by High Quality and Other Investment assets and further classified by type of issuer and by ratings categories. All ARM securities included in the tables have been rated by the Rating Agencies. ARM Loans include securitized ARM loans that have been rated by the Rating Agencies and ARM loans collateralizing debt obligations that have been stratified by credit rating based on the ratings received from the Rating Agencies on the respective CDOs and ARM loans held for securitization that have not been rated by the Rating Agencies.

ARM Assets by Issuer and Credit Rating
(in thousands)

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	(1)		As of March 31, 2004, the AAA Rating category includes $4.1 billion of ARM loans collateralizing CDOs that have been credit enhanced to AAA through overcollateralization in the amount of $30.6 million which is included in the BB/Ba Rating and below category.
	(2)		As of December 31, 2003, the AAA Rating category includes $3.1 billion of ARM loans collateralizing CDOs that have been credit enhanced to AAA through overcollateralization in the amount of $24.1 million which is included in the BB/Ba Rating and below category.

As of March 31, 2004, 5 of the 17,897 loans in our ARM loan portfolio were considered seriously delinquent (60 days or more delinquent) and had an aggregate balance of $1.2 million. The average original effective loan-to-value ratio on the delinquent loans and the acquired property was 78%. We believe that our current level of basis adjustments and allowance for loan losses is adequate to cover estimated losses from these loans.

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     ARM Loan Portfolio Characteristics

The following table presents various characteristics of our ARM Loan portfolio as of March 31, 2004. This information pertains to ARM loans held for securitization, ARM loans held as collateral for CDOs and ARM loans securitized for our own portfolio for which we retained credit loss exposure. The combined unpaid principal balance of the loans included in this information is $8.0 billion.