UNITED STATES SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

[X]

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

For the quarterly period ended: September 30, 2004

OR

[  ]

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

For the transition period from                     to                    

Commission File Number: 001-11914

THORNBURG MORTGAGE, INC.

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 [  ]

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 [  ]

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) 88,963,362 as of November 4, 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

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 September 30, 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”), its wholly owned bankruptcy-remote special purpose finance subsidiary, Thornburg Mortgage Depositor, LLC (“TMD”), its wholly owned mortgage loan origination subsidiary, Thornburg Mortgage Home Loans, Inc. (“TMHL”), TMD’s wholly owned special purpose finance subsidiary, Thornburg Mortgage Capital Resources, LLC (“TMCR”) and TMHL’s two wholly owned special purpose finance subsidiaries, Thornburg Mortgage Funding Corporation II and Thornburg Mortgage Acceptance Corporation II. TMCR and TMD are wholly owned qualified real estate investment trust (“REIT”) subsidiaries and are consolidated with the Company for financial statement and tax reporting purposes. As of the close of business on May 31, 2004, TMHL and its subsidiaries made the election to be taxable REIT subsidiaries and are consolidated with the Company for financial statement purposes but are not consolidated with the Company for tax reporting purposes from that date forward. 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 requires that these commitments be recorded at fair value with changes in fair value recognized in current earnings and was intended to eliminate the diversity in industry practice that existed relating to the accounting for loan commitments. SAB 105 is effective for loan commitments entered into after March 31, 2004. Management believes that the Company’s method of accounting for loan commitments is consistent with the guidance provided by SAB 105.
		In December 2003, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants issued Statement of Position 03-3, “Accounting for Certain Loans or Debt Securities Acquired in a Transfer” (“SOP 03-3”). SOP 03-3 addresses the accounting for acquired impaired loans, loans that show evidence of having deteriorated in terms of credit quality since their origination. SOP 03-3 is effective for loans acquired after December 31, 2004. Because the Company acquires loans generally underwritten to “A” quality standards, the Company does not expect the adoption of SOP 03-3 to have a material effect on the financial condition, results of operations, or liquidity of the Company.
		In June 2004, the Financial Accounting Standards Board (“FASB”) issued Emerging Issues Task Force Abstract 03-01, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (“EITF 03-01”). EITF 03-01 requires an investor to determine when an investment is considered impaired, evaluate whether that impairment is other than temporary, and, if the impairment is other than temporary, recognize an impairment loss equal to the difference between the investment’s cost and its fair value. The guidance also includes accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. The impairment loss recognition and measurement guidance was to be applicable to other-than-temporary impairment evaluations in reporting periods beginning after June 15, 2004. In September 2004, the FASB proposed additional guidance related to debt securities that are impaired because of interest rate and /or sector spread increases, and delayed the effective date of EITF 03-01. The Company does not expect the adoption of EITF 03-01 to have a material effect on the financial condition, results of operations, or liquidity of the Company. EITF 03-01 also includes disclosure

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		requirements for investments in an unrealized loss position for which other-than-temporary impairments have not been recognized. These disclosures are included in the Company’s Form 10-Q Quarterly Report for the quarter ended September 30, 2004 as required by the EITF.
		On March 31, 2004, the FASB issued an exposure draft (the “ED”) entitled Share-Based Payment. If the ED is adopted by the FASB, it would require all public companies to report share-based compensation expense at the grant date fair value of the related share-based awards. In October 2004, the FASB delayed the effective date of this proposed standard. Public companies with calendar year-ends would be required to adopt the provisions of the standard effective for periods beginning after June 15, 2005. Management believes that the Company’s method of accounting for share-based payments is consistent with the guidance provided by the ED.

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 value of cash equivalents approximates their fair value.

Restricted cash and cash equivalents

Restricted cash and cash equivalents includes cash and highly liquid investments with original maturities of three months or less that are held by counter-parties as collateral for reverse repurchase agreements, asset-backed commercial paper and hedging instruments. The carrying amount of restricted cash and cash equivalents approximates their 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. 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 a realized loss. Realized 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 amortized 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 reserve for loan losses.
		Securitized ARM loans are loans originated or acquired by the Company and securitized by the Company with the Company retaining 100% of the beneficial ownership interests.
		ARM loans collateralizing long-term debt are loans the Company has securitized into sequentially rated classes with the lower rated classes providing 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.

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		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 creating highly liquid securitized assets that can be readily financed in the capital markets.
		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. Estimating prepayments and estimating the remaining lives of the Company’s 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 longer or shorter than the amount estimated by management. 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.

Mortgage servicing rights (“MSRs”)

		The Company does not purchase 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 Servicing income, net on the Consolidated Income Statements, rather than being accounted for as interest income.
		MSRs are carried at the lower of cost or fair value at the risk strata level and are periodically evaluated for impairment using a discounted future cash flow model that considers portfolio characteristics and assumptions regarding prepayment speeds, 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).
		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. Estimating prepayments and estimating the remaining lives of the Company’s 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 longer or shorter than the amount estimated by management.

Credit risk and reserve for loan losses

The Company limits its exposure to credit losses on its portfolio of ARM securities by purchasing ARM securities that generally have at least 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. 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 risk. 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

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		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 a reserve for loan losses based on management’s estimate of credit losses inherent in the Company’s portfolio of ARM Loans. The estimation of the reserve 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 reserve 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.
		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 third party pricing services or by certain dealers who make markets in these financial instruments. 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 interest 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 price the Company’s originated ARM Loans, adjusted for anticipated fallout for purchase loan 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 the change in fair value recorded in Gain (loss) on ARM assets and hedging instruments, net on the Consolidated Income Statements.
		The fair values of the Company’s collateralized debt obligations (“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 these instruments.
		The fair value of Eurodollar futures contracts (“Eurodollar Transactions”) 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 and cash equivalents, interest receivable, reverse repurchase agreements, asset-backed commercial paper, 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

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		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.
		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.
		Hybrid ARM 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 ARM 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. Consequently, the Company uses Hybrid ARM Hedging Instruments to fix the interest rate on its borrowings during the expected fixed interest rate period of the Company’s Hybrid ARM assets such that the Company maintains a combined duration on its borrowings and Hybrid ARM Hedging Instruments that closely matches the duration of the Company’s Hybrid ARM assets, the difference being net duration. The notional balances of the Hybrid ARM 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. When the Company enters into a Eurodollar Transaction, it incurs a gain if the applicable interest rate index subsequently rises and a loss if the applicable interest rate index subsequently declines. The amortization of the gain or loss over the hedged period when combined with the variable cost of the short-term debt is expected to result in a fixed interest cost over the life of the Eurodollar Transaction.
		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 so as not to exceed the level specified by the Cap Agreement. The purchase price of these Cap Agreements is expensed over the life of the Cap Agreements and the expense increases as the Cap Agreements approach maturity. Therefore, the expense in future periods is expected to be greater than that experienced currently.
		The Company designates its Hybrid ARM 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 ARM 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 or its debt obligations, 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 ARM Hedging Instruments is included in Hedging instruments on the Consolidated Balance Sheets.

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		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
		In the past, the Company has purchased 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 has discontinued its policy to separately hedge the Life Cap on Traditional ARM assets and, instead, manages this risk as part of the overall management of portfolio duration.
		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 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 (loss) on ARM assets and hedging instruments, net on the Consolidated Income Statements as an offset to the net gain (loss) recorded for the change in fair value of the loan commitments.

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 Financial Accounting Standard 133, “Accounting for Derivative Instruments and Hedging Activities.”
		The net unrealized gain on the Company’s ARM Loans of $65.0 million and $7.9 million at September 30, 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, excluding TMHL and its subsidiaries, 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. TMHL and each of its subsidiaries made the election to be taxable REIT subsidiaries as of the close of business on May 31, 2004 and, as such, are subject to both federal and state corporate income tax after that date. Since being converted to taxable REIT subsidiaries, TMHL and its subsidiaries have recorded an immaterial amount of income and have not recorded a tax provision.

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

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		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- and nine-month periods ended September 30, 2004 and 2003 (in thousands except per share data):

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.

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Note 2. Adjustable-Rate Mortgage Assets

The following tables present the Company’s ARM assets as of September 30, 2004 and December 31, 2003 (in thousands):

		The Company recorded a net gain on ARM assets and hedging instruments of $7.6 million during the nine months ended September 30, 2004. This gain consists of an $11.1 million gain on the sale of $1.1 billion of ARM assets and a $2.1 million realized gain on the termination of three Swap Agreements, partially offset by a net loss of $1.8 million on Eurodollar Transactions hedging the loan commitment pipeline and a net loss of $3.8 million on commitments to purchase loans from correspondent lenders and bulk sellers. The Company realized a gain on ARM assets of $5.4 million during the nine months ended September 30, 2003. This gain consists of a $2.7 million net recovery of estimated credit losses, a $1.8 million net gain on the loan commitments pipeline at September 30, 2003 and a $910.5 thousand gain upon the maturity of a collateralized bond obligation.
		During the nine months ended September 30, 2004, the Company securitized $3.4 billion of its ARM loans into a series of private-label multi-class ARM securities. The Company retained $75.2 million of the securities created for its securitized ARM loan portfolio and placed $3.4 billion of the securities with third party investors, thereby providing long-term collateralized financing for the Company’s assets. Of the securities retained by the Company, $57.7 million were rated Investment Grade and $17.5 million were rated less than Investment Grade. These securities and interest-only subordinate certificates also retained by the Company provide credit support to the securitizations. The Company did not account for these securitizations as sales and, therefore, did not record any gain or loss in connection with the securitizations. As of September 30, 2004, the Company had $9.0 billion of ARM assets as a result of the Company’s securitization efforts. As of December 31, 2003, the Company had $6.9 billion of ARM assets as a result of the Company’s securitization efforts.

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		MSRs capitalized upon the securitization of $3.4 billion of ARM loans during the nine months ended September 30, 2004 totaled $12.3 million. MSRs of $18.0 million, net of amortization during the nine months ended September 30, 2004 of $3.0 million, are included in Prepaid expenses and other on the Consolidated Balance Sheets at September 30, 2004. MSRs of $8.6 million, net of amortization, are included in Prepaid expenses and other on the Consolidated Balance Sheets at December 31, 2003. At September 30, 2004, the fair value of the MSRs in each risk stratum exceeded their cost basis.
		As of September 30, 2004 and December 31, 2003, the Company had basis adjustments of $5.0 million and $3.4 million, respectively, 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 $2.3 million related to ARM securities purchased during the first nine months of 2004 on which the Company had first loss credit exposure. These securities were purchased as part of $1.7 billion of third party loan securitizations in which the Company purchased all classes of the securitizations, including the subordinated classes.
		During the nine months ended September 30, 2004, the Company recorded loan loss provisions totaling $1.1 million to reserve for estimated credit losses on ARM Loans bringing its total loan loss reserve to $9.1 million.
		The following table shows the gross unrealized losses and fair value of ARM securities, aggregated by credit rating and length of time that the 436 individual securities have been in a continuous unrealized loss position, at September 30, 2004 (dollar amounts in thousands):

Unrealized Losses on ARM Securities as of September 30, 2004

The unrealized losses in the above table are temporary impairments due to changes in market interest rates and, based upon review of credit ratings, delinquency data and other information, are not reflective of credit deterioration. As the Company has the ability and intent to hold its ARM securities, losses are not considered to be other than temporary impairments. As presented in Note 7, during the nine-month period ended September 30, 2004, the net unrealized loss of $43.3 million on ARM securities increased by $85.9 million to a net unrealized loss of $129.2 million. During the same nine-month period, the net unrealized loss on hedging instruments of $99.5 million improved by $72.8 million to a net unrealized loss of $26.7 million, for a combined increase in the net unrealized loss on ARM securities and hedging instruments of $13.1 million. Furthermore, although the Company’s ARM securities are designated as available-for-sale, the Company does not typically sell its ARM securities and therefore does not expect to realize these gross unrealized losses.

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The Company has credit exposure on its ARM Loans. The following tables summarize ARM Loan delinquency information as of September 30, 2004 and December 31, 2003 (in thousands, except for loan count):

          September 30, 2004

          December 31, 2003

		As of September 30, 2004, the Company owned one real estate property as a result of foreclosing on a delinquent loan that is included in ARM loans on the Consolidated Balance Sheet in the aggregate amount of $203.5 thousand (not included in the table above.) The Company believes that its current level of reserves is adequate to cover any loss, should one occur, from the sale of this property and losses inherent within the loan portfolio.
		As of September 30, 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. At September 30, 2004, the balance of the Hybrid ARM securities was approximately $1.6 billion, but is expected to be less than 30% of that, and could be zero, at the time they convert into Traditional ARM securities. At September 30, 2004, the remaining balance of securities to be acquired in 2004 was approximately $15.0 million and may pay down to zero by the purchase commitment date. 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 September 30, 2004, the Company had delivered ARM assets with a carrying value of $6.1 million and $3.3 million in cash as collateral in connection with these transactions.

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Note 3. Hedging Instruments

   Hybrid ARM Hedging Instruments

		As of September 30, 2004 and December 31, 2003, the Company was counterparty to Hybrid ARM Hedging Instruments that consist of Swap Agreements and Eurodollar Transactions having aggregate current notional balances of $18.6 billion and $12.5 billion, respectively. In addition, as of September 30, 2004, the Company had entered into delayed Swap Agreements with notional balances totaling $1.5 billion that become effective in the fourth quarter of 2004. These delayed Swap Agreements have been entered into to hedge the financing of the Company’s ARM asset purchase commitments at September 30. 2004.. As of September 30, 2004, these Swap Agreements and Eurodollar Transactions had a weighted average maturity of 3.0 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. The combined weighted average fixed rate payable of the Swap Agreements and Eurodollar Transactions was 3.06% and 3.02% at September 30, 2004 and December 31, 2003, respectively. As of September 30, 2004, ARM assets with a carrying value of $73.6 million, including accrued interest, and cash totaling $42.4 million collateralized the Swap Agreements and Eurodollar Transactions.
		The net unrealized loss on Swap Agreements at September 30, 2004 of $2.0 million included Swap Agreements with gross unrealized losses of $67.0 million and gross unrealized gains of $65.0 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 September 30, 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 $7.2 million. The Company estimates that over the next twelve months, $32.7 million of these net unrealized losses will be reclassified from Accumulated other comprehensive income (loss) to interest expense.
		As of September 30, 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 $1.3 billion and $1.6 billion, respectively. The Company has also entered into Cap Agreements that have start dates ranging from 2006 to 2010. The notional balance at the start date will be the lesser of the scheduled amount of $371.1 million or the balance of Hybrid ARM loans associated with these Cap Agreements. The fair value of all of these Cap Agreements at September 30, 2004 and December 31, 2003 was $16.9 million and $25.4 million, respectively, and is included in Hedging instruments on the Consolidated Balance Sheets. As of September 30, 2004, the unrealized loss on these Cap Agreements of $19.4 million is included in Accumulated other comprehensive income (loss). In the twelve month period following September 30, 2004, $337.8 thousand of this unrealized loss is expected to be realized. Pursuant to the terms of these Cap Agreements and subject to future prepayment behavior, 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 11.50% and average 5.24%. The Cap Agreements had an average maturity of 4.2 years as of September 30, 2004 and will expire between 2006 and 2013.
		The Company hedges the funding of its Hybrid ARM assets such that the net duration, which is the duration of borrowed funds and Hybrid ARM Hedging Instruments minus the duration of Hybrid ARM assets, is less than one year. See a discussion of duration and net duration under Portfolio Strategies on page 32. At September 30, 2004, the financing and hedging of the Company’s Hybrid ARM assets resulted in a net duration of approximately 2.9 months while the financing and hedging of all of the Company’s ARM assets resulted in a net duration of approximately 2.6 months. This suggests a very low degree of portfolio price change given small changes in interest rates, and implies that the Company’s cash flow and earning characteristics should be relatively stable as interest rates change.

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Interest expense for the quarter and nine-month period ended September 30, 2004 includes net payments on Hybrid ARM Hedging Instruments of $62.5 million and $190.8 million, respectively. Interest expense for the same periods in 2003 includes net payments on Hybrid ARM Hedging Instruments of $40.9 million and $107.6 million, respectively.

   Life Cap Hedging Instruments

The Life Cap Hedging Instruments had a fair value of $0 at September 30, 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. These Cap Agreements had a remaining notional amount of $200.0 million and $841.3 million as of September 30, 2004 and December 31, 2003, respectively. The Company will receive cash payments should the three-month LIBOR increase above the contract rates of these Hedging Instruments, which range from 8.00% to 8.25% and average 8.13%. The Life Cap Hedging Instruments had an average final maturity of 3.2 months as of September 30, 2004 and expire in January 2005. During the three- and nine-month periods ended September 30, 2004, the Company recognized expenses of $149.2 thousand and $456.5 thousand, respectively, which is reported as Hedging expense in the Company’s Consolidated Income Statements. During the three- and nine-month periods ended September 30, 2003, the Company recognized expenses of $145.0 thousand and $541.8 thousand, respectively.

   Pipeline Hedging Instruments

The fair value of the Pipeline Hedging Instruments at September 30, 2004 and December 31, 2003 was a net unrealized loss of $5.1 million and a net unrealized gain of $953.4 thousand, respectively, and is included in Hedging instruments on the Consolidated Balance Sheets. Pipeline Hedging Instruments had remaining notional balances of $357.0 million and $283.0 million at September 30, 2004 and December 31, 2003, respectively. During the three- and nine-month periods ended September 30, 2004, the Company recognized a $8.3 million loss and a $1.8 million loss, respectively, on Pipeline Hedging Instruments, which is included in Gain (loss) on ARM assets and hedging instruments, net, in the Company’s Consolidated Income Statements along with a $5.4 million gain and a $3.8 million loss recorded on loan commitments for the three- and nine-month periods ended September 30, 2004, respectively.

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 September 30, 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 September 30, 2004, the Company had $15.1 billion of reverse repurchase agreements outstanding with a weighted average borrowing rate of 1.89% and a weighted average remaining maturity of 2.7 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 September 30, 2004, $13.2 billion of the Company’s borrowings were variable-rate term reverse repurchase agreements with original maturities that range from two 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 $12.2 billion, including accrued interest, collateralized the reverse repurchase agreements at September 30, 2004. The Company held cash collateral from reverse repurchase agreement counterparties totaling $12.2 million at September 30, 2004.

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At September 30, 2004, the reverse repurchase agreements had the following remaining maturities (in thousands):

   Asset-backed Commercial Paper Facility

On June 30, 2004, the Company established a new $5 billion asset-backed commercial paper facility, which provides an alternative way to finance the Company’s high quality ARM securities portfolio. Through a wholly owned bankruptcy–remote special purpose subsidiary, the Company issues asset-backed commercial paper to investors in the form of secured liquidity notes that are recorded as borrowings on the Company’s Consolidated Balance Sheets and are rated P-1 by Moody’s Investors Services and F1+ by Fitch Ratings. As of September 30, 2004, the Company had $3.2 billion of asset-backed commercial paper outstanding with a weighted average interest rate of 1.85% and a weighted average remaining maturity of 27 days.

As of September 30, 2004, these notes were collateralized by AAA-rated mortgage-backed securities from the Company’s ARM securities portfolio with a carrying value of $3.4 billion, including accrued interest.

   CDOs

		On September 29, 2004, $1.3 billion of ARM loans from the Company’s ARM loan portfolio were transferred to Thornburg Mortgage Securities Trust 2004-3 and were securitized. In this transaction, the Company through its securities underwriter issued AAA-rated floating-rate pass-through certificates totaling $1.2 billion to third party investors and the Company retained the subordinated certificates, which provide credit support to the AAA certificates. The interest rates on the floating-rate pass-through certificates reset monthly and are indexed to the one-month LIBOR rate. In connection with the issuance of these CDOs, the Company incurred costs of $4.0 million, which were deducted from the proceeds of the transaction and are being amortized over the expected life of the CDOs. This transaction was accounted for as a financing of loans and represents permanent financing that is not subject to margin calls.
		All of the Company’s CDOs 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 September 30, 2004, the following CDOs were outstanding (in thousands):

	(1)		Effective interest rate includes the impact of issuance costs and Hedging Instruments.
	(2)		Includes financing hedged with Cap Agreements with a notional balance of $1.3 billion and a weighted average strike price of 5.24% as of September 30, 2004.

As of September 30, 2004, the CDOs were collateralized by ARM loans with a principal balance of $5.8 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 September 30, 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 November 2004 and March 2005. The Company expects to renew these facilities. As of September 30, 2004, the Company had $297.5 million borrowed against these whole loan financing facilities at an effective cost of 2.76%. 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 September 30, 2004 was collateralized by ARM loans with a carrying value of $308.5 million, including accrued interest. These facilities have covenants that are standard for industry practice and the Company was in compliance with all such covenants at September 30, 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 is 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

		In 2003, the Company issued $255.0 million in 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 September 30, 2004 and December 31, 2003, the balance of the Senior Notes outstanding, net of unamortized issuance costs, was $251.4 million and $251.1 million, respectively.
		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 September 30, 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 $155.6 million and $85.7 million for the quarters ended September 30, 2004 and 2003, respectively, and $421.7 million and $232.3 million for the nine months ended September 30, 2004 and 2003, respectively.

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   Contractual Obligations

As of September 30, 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 September 30, 2004 and December 31, 2003 (in thousands):