UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

or

Commission File Number: 000-31828

LUMINENT MORTGAGE CAPITAL, INC.

(415) 486-2110
(Registrant’s Telephone Number, Including Area Code)

N/A
(Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report)

          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 Exchange Act). Yes o No x.

          The number of shares of our common stock outstanding on July 31, 2004 was 36,900,193.

INDEX

i

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

          This Quarterly Report on Form 10-Q contains certain forward-looking statements. Forward looking statements are those which are not historical in nature. They can often be identified by their inclusion of words such as “will,” “anticipate,” “estimate,” “should,” “expect,” “believe,” “intend” and similar expressions. Any projection of revenues, earnings or losses, capital expenditures, distributions, capital structure or other financial terms is a forward-looking statement.

          Our forward-looking statements are based upon our management’s beliefs, assumptions and expectations of our future operations and economic performance, taking into account the information currently available to us. Forward-looking statements involve risks and uncertainties, some of which are not currently known to us, that might cause our actual results, performance or financial condition to be materially different from the expectations of future results, performance or financial condition we express or imply in any forward-looking statements. Some of the important factors that could cause our actual results, performance or financial condition to differ materially from expectations are:

	•		our limited operating history;
	•		interest rate mismatches between our mortgage-backed securities and our borrowings used to fund such purchases;
	•		changes in interest rates and mortgage prepayment rates;
	•		effects of interest rate caps on our adjustable-rate mortgage-backed securities;
	•		the degree to which our hedging strategies may or may not protect us from interest rate volatility;
	•		potential impacts of our leveraging policies on our net income and cash available for distribution;
	•		our ability to invest up to 10% of our investment portfolio in lower-credit quality mortgage-backed securities which carry an increased likelihood of default or rating downgrade relative to investment-grade securities;
	•		our board’s ability to change our operating policies and strategies without notice to you or stockholder approval;
	•		Seneca Capital Management LLC’s motivation to recommend riskier investments in an effort to maximize its incentive compensation under the management agreement;
	•		potential conflicts of interest arising out of our relationship with Seneca Capital Management LLC, on the one hand, and Seneca Capital Management LLC’s relation with other third parties, on the other hand; and
	•		the other important factors described in this Quarterly Report on Form 10-Q, including those under the captions “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Risk Factors,” and “Quantitative and Qualitative Disclosures about Market Risk.”

          We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. In light of these risks, uncertainties and assumptions, the events described by our forward-looking events might not occur. We qualify all of our forward-looking statements by these cautionary factors. In addition, you should carefully review the risk factors described in other documents we file from time to time with the Securities and Exchange Commission.

          This Quarterly Report on Form 10-Q contains market data, industry statistics and other data that have been obtained from, or compiled from, information made available by third parties. We have not independently verified their data.

ii

PART I

FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

INDEX TO FINANCIAL STATEMENTS

1

LUMINENT MORTGAGE CAPITAL, INC.

CONDENSED BALANCE SHEETS

(Unaudited)

See notes to financial statements

2

LUMINENT MORTGAGE CAPITAL, INC.

CONDENSED STATEMENTS OF OPERATIONS

(Unaudited)

See notes to financial statements

3

LUMINENT MORTGAGE CAPITAL, INC.

CONDENSED STATEMENT OF STOCKHOLDERS’ EQUITY

(Unaudited)

See notes to financial statements

4

LUMINENT MORTGAGE CAPITAL, INC.

CONDENSED STATEMENTS OF CASH FLOWS

(Unaudited)

See notes to financial statements

5

LUMINENT MORTGAGE CAPITAL, INC.

NOTES TO FINANCIAL STATEMENTS

(Unaudited)

NOTE 1-ACCOUNTING POLICIES

          Luminent Mortgage Capital, Inc., or the Company, is a real estate investment trust which invests primarily in U.S. agency and other highly-rated single-family, adjustable-rate, hybrid adjustable-rate and fixed rate mortgage-backed securities. Seneca Capital Management LLC, or the Manager, pursuant to a management agreement, or the Management Agreement, manages the Company and its investment portfolio.

          The accounting and reporting policies of the Company conform with accounting principles generally accepted in the United States of America, or GAAP. Preparing the financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and income and expenses during the reporting period.

          The information furnished in these unaudited condensed interim statements reflects all adjustments that are, in the opinion of management, necessary for a fair statement of the results for the periods presented. These adjustments are of a normal recurring nature, unless otherwise disclosed in this Form 10-Q. The results of operations in the interim statements do not necessarily indicate the results that may be expected for the full year. The interim financial information should be read in conjunction with the Company’s 2003 Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 3, 2004 (file number 001-31828).

          Descriptions of the significant accounting policies of the Company are included in Note 1 to financial statements in the Company’s 2003 Annual Report on Form 10-K. There have been no significant changes to these policies during 2004.

Recent Accounting Pronouncements

          In March 2004, the Emerging Issues Task Force, or EITF, reached a consensus on Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. This Issue provides clarification with respect to the meaning of other-than-temporary impairment and its application to investments classified as either available-for-sale or held-to-maturity under Statement of Financial Accounting Standards, or SFAS, No. 115, Accounting for Certain Investments in Debt and Equity Securities, (including individual securities and investments in mutual funds), and investments accounted for under the cost method or the equity method. The guidance for evaluating whether an investment is other-than-temporarily impaired must be applied in other-than-temporary impairment evaluations made in reporting periods beginning after June 15, 2004. This Issue did not have a material impact on the Company’s financial statements.

6

LUMINENT MORTGAGE CAPITAL, INC.

NOTES TO FINANCIAL STATEMENTS — (Continued)

(Unaudited)

NOTE 2-MORTGAGE-BACKED SECURITIES

          The following table summarizes the Company’s mortgage-backed securities classified as available-for-sale at June 30, 2004, which are carried at fair value:

          The following table summarizes the Company’s mortgage-backed securities classified as available-for-sale at December 31, 2003, which are carried at fair value:

          At June 30, 2004 and December 31, 2003, 63.9% and 63.0%, respectively, of the Company’s mortgage-backed securities portfolio, as measured by its fair value, was agency-guaranteed.

          Actual maturities of mortgage-backed securities are generally shorter than stated contractual maturities. Actual maturities of the Company’s mortgage-backed securities are affected by the contractual lives of the underlying mortgages, periodic payments of principal, and prepayments of principal. The following table summarizes the Company’s mortgage-backed securities on June 30, 2004 according to their estimated weighted-average life classifications:

7

LUMINENT MORTGAGE CAPITAL, INC.

NOTES TO FINANCIAL STATEMENTS — (Continued)

(Unaudited)

          The following table summarizes the Company’s mortgage-backed securities on December 31, 2003 according to their estimated weighted-average life classifications:

          The weighted-average lives of the mortgage-backed securities at June 30, 2004 and December 31, 2003 in the tables above are based upon data provided through subscription-based financial information services, assuming constant principal prepayment rates to the balloon or reset date for each security. The prepayment model considers current yield, forward yield, steepness of the yield curve, current mortgage rates, mortgage rate of the outstanding loan, loan age, margin and volatility.

          The actual weighted-average lives of the mortgage-backed securities in the Company’s investment portfolio could be longer or shorter than the estimates in the table above depending on the actual prepayment rates experienced over the lives of the applicable securities and are sensitive to changes in both prepayment rates and interest rates.

          The following table shows the Company’s investments’ fair value and gross unrealized losses, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at June 30, 2004:

8

LUMINENT MORTGAGE CAPITAL, INC.

NOTES TO FINANCIAL STATEMENTS — (Continued)

(Unaudited)

          The following table shows the Company’s investments’ fair value and gross unrealized losses, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2003:

          At June 30, 2004 and December 31, 2003 the Company was only invested in AAA-rated non-agency-backed or agency-backed mortgage-backed securities. The temporary impairment of the available-for-sale securities results from the fair value of the securities falling below the amortized cost basis. At June 30, 2004 and December 31, 2003, none of the securities held by the Company had been downgraded by a credit rating agency since their purchase. Management intends to hold the securities until maturity, allowing for the anticipated recovery in fair value of the securities held. As such, management does not believe any of the securities held are other-than-temporarily impaired at June 30, 2004 or December 31, 2003.

NOTE 3-REPURCHASE AGREEMENTS AND OTHER BORROWINGS

          The Company has entered into repurchase agreements with third party financial institutions to finance most of its mortgage-backed securities. The repurchase agreements are short-term borrowings that bear interest rates that have historically moved in close relationship to the three-month London Interbank Offered Rate, or LIBOR. At June 30, 2004 and December 31, 2003, the Company had repurchase agreements with an outstanding balance of $3.8 billion and $1.7 billion, respectively, and with weighted-average interest rates of 1.31% and 1.19%, respectively. At June 30, 2004 and December 31, 2003 securities pledged as collateral for repurchase agreements had estimated fair values of $4.1 billion and $1.8 billion, respectively.

9

LUMINENT MORTGAGE CAPITAL, INC.

NOTES TO FINANCIAL STATEMENTS — (Continued)

(Unaudited)

          At June 30, 2004, the repurchase agreements had remaining maturities as summarized below:

10

LUMINENT MORTGAGE CAPITAL, INC.

NOTES TO FINANCIAL STATEMENTS — (Continued)

(Unaudited)

          At December 31, 2003, the repurchase agreements had remaining maturities as summarized below:

11

LUMINENT MORTGAGE CAPITAL, INC.

NOTES TO FINANCIAL STATEMENTS — (Continued)

(Unaudited)

          At June 30, 2004, the repurchase agreements had the following counterparties, amounts at risk and weighted-average remaining maturities:

(1)

Equal to the sum of fair value of securities sold plus accrued interest income minus the sum of repurchase agreement liabilities plus accrued interest expense.

          At December 31, 2003, the repurchase agreements had the following counterparties, amounts at risk and weighted-average remaining maturities:

(1)

Equal to the sum of fair value of securities sold plus accrued interest income minus the sum of repurchase agreement liabilities plus accrued interest expense.

12

LUMINENT MORTGAGE CAPITAL, INC.

NOTES TO FINANCIAL STATEMENTS — (Continued)

(Unaudited)

          The Company had a note payable of $294 thousand and $92 thousand at June 30, 2004 and December 31, 2003, respectively, for the purpose of financing its annual directors’ and officers’ insurance premium at the annual interest rate of 4.91% and 6.50%, respectively.

          The Company has a margin lending facility with its primary custodian whereby it may borrow money in connection with the purchase or sale of securities. The terms of the borrowings, including the rate of interest payable, will be agreed to with the custodian for each amount borrowed. Borrowings are repayable immediately upon demand by the custodian. At June 30, 2004 and December 31, 2003, there were no outstanding borrowings under the margin lending facility.

     NOTE 4—CAPITAL STOCK AND NET INCOME PER SHARE

          The Company had 100,000,000 shares of par value $0.001 common stock authorized and 36,900,193 shares and 24,814,000 shares were issued and outstanding at June 30, 2004 and December 31, 2003, respectively. Of the 100,000,000 shares of par value $0.001 common stock authorized, 10,000,000 shares are reserved for issuance in order to pay incentive fees in connection with the Management Agreement. At June 30, 2004 and December 31, 2003, 9,918,500 shares and 9,974,349 shares, respectively, remain reserved for issuance. The Company had 10,000,000 shares of par value $0.001 preferred stock authorized and none outstanding at June 30, 2004 or December 31, 2003.

          On March 29, 2004, the Company completed a public offering of 12,000,000 shares of its common stock, $0.001 par value, at an offering price of $14.00 per share. The Company received proceeds from the public offering in the amount of $157.5 million, net of underwriting discount and other offering costs.

          The Company calculates basic net income per share by dividing net income for the period by the weighted-average shares of its common stock outstanding for that period. Diluted net income per share takes into account the effect of dilutive instruments, such as stock options and unvested restricted stock, but uses the average share price for the period in determining the number of incremental shares that are to be added to the weighted-average number of shares outstanding.

          The following table presents a reconciliation of basic and diluted net income per share for the three and six months ended June 30, 2004:

          For the period from April 26, 2003 through June 30, 2003, basic net income per share was $0.04. The Company had no dilutive instruments and therefore diluted net income per share was equal to basic net income per share.

13

LUMINENT MORTGAGE CAPITAL, INC.

NOTES TO FINANCIAL STATEMENTS — (Continued)

(Unaudited)

     NOTE 5—2003 STOCK INCENTIVE PLANS

          The Company adopted a 2003 Stock Incentive Plan, effective June 4, 2003, and a 2003 Outside Advisors Stock Incentive Plan, effective June 4, 2003, pursuant to which up to 1,000,000 shares of the Company’s common stock is authorized to be awarded at the discretion of the Compensation Committee of the Board of Directors. The plans provide for the grant of a variety of long-term incentive awards to employees and officers of the Company, individual consultants or advisors who render or have rendered bona fide services, and to officers, employees or directors of the Manager as an additional means to attract, motivate, retain and reward eligible persons. These plans provide for the grant of awards that meet the requirements of Section 422 of the Internal Revenue Code, non-qualified stock options, stock appreciation rights, restricted stock, stock units and other stock-based awards, and dividend equivalent rights. The maximum term of each grant is determined on the grant date by the Compensation Committee and shall not exceed 10 years. The exercise price and the vesting requirement of each grant is determined on the grant date by the Compensation Committee.

          The following table sets forth the common stock available for grant at June 30, 2004:

	(1)		At June 4, 2003, adoption date of both stock incentive plans, the maximum number of shares of common stock that may be issued pursuant to awards granted under these combined plans is 1,000,000 shares.
	(2)		At June 30, 2004, the maximum number of shares of common stock that may be issued pursuant to awards granted under these combined plans is 940,307 shares.

          At June 30, 2004, the Company had outstanding options under the plans with expiration dates of 2013. The following table summarizes all stock option transactions during the six months ended June 30, 2004:

14

LUMINENT MORTGAGE CAPITAL, INC.

NOTES TO FINANCIAL STATEMENTS — (Continued)

(Unaudited)

          The following table summarizes certain information about stock options outstanding at June 30, 2004:

          Total stock-based employee compensation expense related to stock options for the three and six months ended June 30, 2004 was $2 thousand and $3 thousand, respectively.

          The following table illustrates restricted common stock transactions during the six months ended June 30, 2004:

          There were no stock option or restricted common stock transactions during the period from June 4, 2003, the effective date of the 2003 Stock Incentive Plan and the 2003 Outside Advisors Stock Incentive Plan, through June 30, 2003.

NOTE 6—THE MANAGEMENT AGREEMENT

          The Company has entered into a Management Agreement with the Manager that provides, among other things, that the Company will pay to the Manager, in exchange for investment management and certain administrative services, certain fees and reimbursements, summarized as follows:

•

a base management fee equal to a percentage of average net worth during each fiscal year as defined in the Management Agreement (1% of the first $300 million plus 0.8% of the amount in excess of $300 million);

•

incentive compensation based on the excess of a “tiered percentage” (as defined in the Management Agreement as the weighted-average of the following rates based upon average net invested assets: (1) 20% for the first $400 million of average net invested assets; and (2) 10% for the average net invested assets in excess of $400 million) of the difference between the Company’s net income (defined in the Management Agreement as taxable income before incentive compensation, net operating losses from prior periods, and items permitted by the Internal Revenue Code when calculating taxable income for a REIT) and the “threshold return” (the amount of net income for the period that would produce an annualized return on equity, calculated by dividing the net income, as defined in the Management Agreement, by the average net invested assets, as defined in the Management Agreement, equal to the 10-year U.S. Treasury rate for the period plus 2.0%) for the fiscal period; and

•

out-of-pocket expenses and certain other costs incurred by the Manager and related directly to the Company.

15

LUMINENT MORTGAGE CAPITAL, INC.

NOTES TO FINANCIAL STATEMENTS — (Continued)

(Unaudited)

          The base management fee and incentive compensation will be paid quarterly and are subject to adjustment at the end of each fiscal year based on annual results. One-half of the incentive compensation will be paid to the Manager in cash and one-half will be paid in the form of a restricted stock award. The number of shares issued is based on (a) one-half of the total incentive compensation for the period, divided by (b) the average of the closing prices of the common stock over the 30-day period ending three calendar days prior to the grant date, less a fair market value discount determined by the Company’s Board of Directors. These shares are “restricted shares” for varying periods of time, and are forfeitable if the Manager ceases to perform management services for the Company before the end of the restriction periods. The Company’s restrictions lapse and full rights of ownership vest for one-third of the shares on the first anniversary of the end of the period in which the incentive compensation is calculated, for one-third of the shares on the second anniversary and for the last one-third of the shares on the third anniversary. Vesting is predicated on the continuing involvement of the Manager in providing services to the Company.

          From and after June 11, 2004, the Company is entitled to terminate the Management Agreement without cause provided that the Company gives the Manager at least 60 days’ prior written notice and pays a termination fee and other unpaid costs and expenses reimbursable to the Manager. If the Company’s terminates the Management Agreement without cause, the Company is required to pay the Manager a termination fee as follows:

•

If the Company terminates the Management Agreement without cause in connection with a decision to manage its portfolio internally, rather than by an external manager, the amount of the termination fee shall be equal to the amount of the highest annual base fee and the highest annual incentive compensation, for a particular year, earned by the Manager during any of the three years (or on an annualized basis if a lesser period) preceding the effective date of the termination, plus accelerated vesting on the equity component of all incentive compensation.

•

If the Company terminates the Management Agreement without cause for any other reason, the amount of the termination fee shall be equal to two times the amount of the highest annual base fee and the highest annual incentive compensation, for a particular year, earned by the Manager during any of the three years (or on an annualized basis if a lesser period) preceding the effective date of the termination, plus all deferred payments, including accelerated vesting on the equity component of all incentive compensation.

          The Company is also entitled to terminate the Management Agreement with cause, in which case the Company is only obligated to reimburse the Manager for its unpaid costs and expenses.

          The Management Agreement contains certain provisions requiring the Company to indemnify the Manager for costs (e.g., legal costs) the Manager could potentially incur in fulfilling its duties prescribed in the Management Agreement or in other agreements related to the Company’s activities. The indemnification provisions do not apply under all circumstances (e.g., if the Manager is grossly negligent, acted with reckless disregard or engaged in willful misconduct or active fraud). The provisions contain no limitation on maximum future payments. The Company has evaluated the impact of these guarantees on its financial statements and determined that it is immaterial.

          The base management fee for the three and six months ended June 30, 2004 was $1.1 million and $1.9 million, respectively. The base management fee for the period from April 26, 2003 to June 30, 2003 was $85 thousand.

          For the three months ended June 30, 2004, REIT taxable income (before deducting incentive compensation, net operating losses and certain other items) was $17.0 million and was greater than the “threshold return” taxable income of $7.7 million. For the six months ended June 30, 2004, REIT taxable income (before deducting incentive compensation, net operating losses and certain other items) was $28.2 million and was greater than the “threshold return” taxable income of $12.4 million.

16

LUMINENT MORTGAGE CAPITAL, INC.

NOTES TO FINANCIAL STATEMENTS — (Continued)

(Unaudited)

          For the three months ended June 30, 2004, total incentive fees earned by the Manager were $1.8 million, one-half payable in cash and one-half payable in the form of the Company’s common stock. The cash portion of the incentive fee of $923 thousand for the three months ended June 30, 2004 was expensed in that period. In accordance with SFAS No. 123, and related interpretations, and EITF 96-18, 15.2% of the restricted stock portion of the incentive fees, or $141 thousand, was expensed in the three months ended June 30, 2004. Included in other assets at June 30, 2004 is $783 thousand of deferred compensation which will be reclassified to stockholders’ equity after the restricted stock is issued and will be expensed over the three-year vesting period of the restricted stock.

          For the six months ended June 30, 2004, total incentive fees earned by the Manager were $3.1 million, one-half payable in cash and one-half payable in the form of the Company’s common stock. The cash portion of the incentive fee of $1.6 million for the six months ended June 30, 2004 was expensed in that period. In accordance with SFAS No. 123, and related interpretations, and EITF 96-18, 15.2% of the restricted stock portion of the incentive fees, or $240 thousand, was expensed in the six months ended June 30, 2004.

          For the period from April 26, 2003 through June 30, 2003, REIT taxable net income (before deducting incentive compensation, net operating losses and certain other items) was $298 thousand and was less than the “threshold return” net income of $426 thousand and, therefore, no incentive fee was earned by the Manager or paid by the Company for that period

          In accordance with the terms of his employment agreement, the Company’s Chief Financial Officer earned an incentive fee of $92 thousand for the three months ended June 30, 2004. This incentive fee is also payable one-half in cash and one-half in the form of a restricted stock award under the Company’s 2003 Stock Incentive Plan. The shares are payable and vest over the same vesting schedule as the stock issued to the Manager. The cash portion of the incentive fee of $46 thousand for the three months ended June 30, 2004 was expensed in that period. In accordance with SFAS No. 123, and related interpretations, and EITF 96-18, 15.2% of the restricted stock portion of the incentive fees, or $7 thousand, was expensed in the three months ended June 30, 2004. Included in other assets at June 30, 2004 is $39 thousand of deferred compensation which will be reclassified to stockholders’ equity after the restricted stock is issued and will be expensed over the three-year vesting period of the restricted stock.

          The Company’s Chief Financial Officer earned an incentive fee of $157 thousand for the six months ended June 30, 2004. This incentive fee is payable one-half in cash and one-half in the form of a restricted stock award under the Company’s 2003 Stock Incentive Plan. The shares are payable and vest over the same vesting schedule as the stock issued to the Manager. The cash portion of the incentive fee of $79 thousand for the six months ended June 30, 2004 was expensed in that period. In accordance with SFAS No. 123, and related interpretations, and EITF 96-18, 15.2% of the restricted stock portion of the incentive fees, or $12 thousand, was expensed in the six months ended June 30, 2004.

          The Chief Financial Officer began employment on August 4, 2003. As such, no incentive compensation was earned by or paid to the Chief Financial Officer for the period from April 26, 2003 through June 30, 2003.

NOTE 7—RELATED PARTY TRANSACTIONS

          At June 30, 2004 and December 31, 2003, the Company was indebted to the Manager for base management fees of $1.1 million and $418 thousand, respectively, and incentive fees of $1.8 million and $606 thousand, respectively. At December 31, 2003 the Company was indebted to the Manager for reimbursement of expenses of $16 thousand. At June 30, 2004 and December 31, 2003, the Company was indebted to the Company’s Chief Financial Officer for incentive fees of $124 thousand and $30 thousand, respectively, and to officers and employees of the Company for bonuses and expense reimbursement of $13 thousand and $18 thousand, respectively. These amounts are included in management fee payable, incentive fees payable and other related party liabilities.

17

LUMINENT MORTGAGE CAPITAL, INC.

NOTES TO FINANCIAL STATEMENTS — (Continued)

(Unaudited)

          The Manager’s financial relationship with the Company is governed by the Management Agreement. Under the Management Agreement, the Manager shall be responsible for all expenses of the personnel employed by the Manager, and all facilities and overhead expenses of the Manager required for the day-to-day operations of the Company, and the expenses of a sub-manager, if any. The Company shall reimburse the Manager for its pro-rata portion of facilities and overhead expenses to the extent that the Company’s employees (who are not also employed by the Manager) use such facilities or incur such expenses pursuant to a cost-sharing agreement entered into between the Company and the Manager. At June 30, 2004 and December 31, 2003, there were no expenses payable to the Manager pursuant to the cost-sharing agreement. During the three and six months ended June 30, 2004, the Company paid the Manager $6 thousand and $12 thousand pursuant to the cost-sharing agreement, respectively. For the period from April 26, 2003 through June 30, 2003, there were no costs incurred pursuant to the cost-sharing agreement. The Company shall pay all other expenses on behalf of the Company, and shall reimburse the Manager for all direct expenses incurred on the Company’s behalf that are not the Manager’s specific responsibility as defined in the Management Agreement.

NOTE 8—FAIR VALUE OF FINANCIAL INSTRUMENTS

          SFAS No. 107, Disclosure About Fair Value of Financial Instruments, requires disclosure of the fair value of financial instruments for which it is practicable to estimate that value. The fair value of mortgage-backed securities available-for-sale and futures contracts is equal to their carrying value presented in the balance sheet. The fair value of cash and cash equivalents, interest receivable, repurchase agreements, unsettled security purchases, and accrued interest expense, approximates cost at June 30, 2004 and December 31, 2003, due to the short-term nature of these instruments.

NOTE 9—ACCUMULATED OTHER COMPREHENSIVE LOSS

          The following is a summary of the components of accumulated other comprehensive loss at June 30, 2004 and December 31, 2003:

          See Note 10 for further discussion regarding derivative instruments and hedging activities.

     NOTE 10—DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES

          The Company seeks to manage its interest rate risk exposure and protect the Company’s repurchase agreement liabilities against the effects of major interest rate changes upon their repricing/maturity. Among other strategies, the Company may use Eurodollar futures contracts and interest rate swaps to manage this interest rate risk. Derivative instruments are carried at fair value.

18

LUMINENT MORTGAGE CAPITAL, INC.

NOTES TO FINANCIAL STATEMENTS — (Continued)

(Unaudited)

          The following table is a summary of derivative instruments held at June 30, 2004:

          The following table is a summary of derivative instruments held at December 31, 2003:

          Cash Flow Hedging Strategies

          Hedging instruments are designated as cash flow hedges, as appropriate, based upon the specifically identified exposure. The hedged transaction is the forecasted interest expense on forecasted rollover/reissuance of repurchase agreements or the interest rate repricing of repurchase agreements for a specified future time period. The hedged risk is the variability in those payments due to changes in the benchmark rate. Hedging transactions are structured at inception so that the notional amounts of the hedge are matched with an equal amount of repurchase agreements forecasted to be outstanding in that specified period for which the borrowing rate is not yet fixed. Cash flow hedging strategies include the utilization of Eurodollar futures contracts and interest rate swap contracts. Hedging instruments under these strategies are deemed to be broadly designated to the outstanding repurchase portfolio and the forecasted rollover thereof. Such forecasted rollovers would also include other types of borrowing arrangements that may replace the repurchase funding during the identified hedge time periods. At June 30, 2004 and December 31, 2003, the maximum length of time over which the Company is hedging its exposure was 15 months and 12 months, respectively.

          Prior to the end of the specified hedge time period, the effective portion of all contract gains and losses (whether realized or unrealized) is recorded in other comprehensive income or loss. Realized gains and losses are reclassified into earnings as an adjustment to interest expense during the specified hedge time period.

          The Company may use Eurodollar futures contracts to hedge the forecasted interest expense associated with the benchmark rate on forecasted rollover/reissuance of repurchase agreements or the interest rate repricing of repurchase agreements for a specified future time period, which is defined as the calendar quarter immediately following the contract expiration date. Gains and losses on each contract are associated with forecasted interest expense for the specified future period.

          The Company may use interest rate swap contracts to hedge the forecasted interest expense associated with the benchmark rate on forecasted rollover/reissuance of repurchase agreements or the interest rate repricing of repurchase agreements for the period defined by maturity of the interest rate swap. Cash flows that occur each time the swap is repriced will be associated with forecasted interest expense for a specified future period, which is defined as the calendar period preceding each repricing date with the same number of months as the repricing frequency.

19

LUMINENT MORTGAGE CAPITAL, INC.

NOTES TO FINANCIAL STATEMENTS — (Continued)

(Unaudited)

          The hedge instrument must be highly effective in achieving offsetting changes in the hedged item attributable to the risk being hedged in order to qualify for hedge accounting. In order to determine whether the hedge instrument is highly effective, the Company uses regression methodology to assess the effectiveness of its hedging strategies. Specifically, at the inception of each new hedge and on an ongoing basis, the Company assesses effectiveness using “ordinary least squares” regression to evaluate the correlation between the rates consistent with the hedge instrument and the underlying hedged items. A hedge instrument is highly effective if the changes in the fair value of the derivative provide offset of at least 80% and not more than 120% of the changes in fair value or cash flows of the hedged item attributable to the risk being hedged. The futures and interest rate swap contracts are carried on the balance sheet at fair value. Any ineffectiveness which arises during the hedging relationship is recognized in interest expense during the period in which it arises.

          During both the three and six months ended June 30, 2004, gains of $2.0 million were recognized in interest expense due to hedge ineffectiveness. During both the three and six months ended June 30, 2004, interest expense was increased by $412 thousand of amortization of realized losses on futures contracts and by $511 thousand paid to swap contract counterparties. Based upon the combined amounts of $1.9 million of net deferred realized gains and $7.8 million of net unrealized gains from Eurodollar futures contracts included in accumulated other comprehensive income and loss at June 30, 2004, the Company expects to recognize lower interest expense during the remainder of 2004 and part of 2005. This amount could differ from amounts actually realized due to changes in the benchmark rate between June 30, 2004 and when the Eurodollar futures contracts sold short at June 30, 2004 are covered, as well as the addition of other hedges subsequent to June 30, 2004.

          The Company was not engaged in derivative instruments and hedging activities during the period from April 26, 2003 through June 30, 2003.

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

          The following discussion of our financial condition and results of operations should be read in conjunction with the financial statements and notes to those statements included elsewhere in this document. This discussion may contain forward-looking statements that involve risks and uncertainties. The words “believe,” “expect,” “anticipate,” “estimate,” “may,” “will,” or “could” and similar expressions or the negatives of these words or phrases are intended to identify forward-looking statements. As a result of many factors, such as those set forth under “Risk Factors” and elsewhere in this document, our actual results may differ materially from those anticipated in such forward-looking statements.

General

          Luminent Mortgage Capital, Inc. is a REIT headquartered in San Francisco, California. We were incorporated in April 2003 to invest primarily in U.S. agency and other highly-rated, single-family, adjustable-rate, hybrid adjustable-rate and fixed-rate mortgage-backed securities, which we acquire in the secondary market. Substantive operations began in mid-June 2003, after completing a private placement of our common stock. Our strategy is to acquire mortgage-related assets, finance these purchases in the capital markets and use leverage in order to provide an attractive return on stockholders’ equity. Through this strategy, we seek to earn income, which is generated from the spread between the yield on our earning assets and our costs, including the interest cost of the funds we borrow. We have acquired and will seek to acquire additional assets that will produce competitive returns, taking into consideration the amount and nature of the anticipated returns from the investment, our ability to pledge the investment for secured, collateralized borrowings and the costs associated with financing, managing, securitizing and reserving for these investments.

          Our business is affected by a variety of economic and industry factors. The most significant risk factors management considers while managing the business which could have a material adverse effect on the financial condition and results of operations are:

•

interest rate mismatches between our adjustable-rate and hybrid adjustable-rate mortgage-backed securities and our borrowings used to fund our purchases of mortgage-backed securities;

•

increasing or decreasing levels of prepayments on the mortgages underlying our mortgage-backed securities;

•

the potential for increased borrowing costs related to repurchase agreements;

•

interest rate caps related to our adjustable-rate and hybrid adjustable-rate mortgage-backed securities;

•

the overall leverage of our portfolio;

•

our ability or inability to use derivatives to mitigate our interest rate and prepayment risks;

•

the impact that increases in interest rates would have on our book value;

•

maintaining adequate borrowing capacity so that we can purchase mortgage-related assets and reach our desired amount of leverage;

•

if we fail to obtain or renew sufficient funding on favorable terms or at all, we will be limited in our ability to acquire mortgage-related assets;

•

possible market developments could cause our lenders to require us to pledge additional assets as collateral;

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•

if our assets are insufficient to meet the collateral requirements, we might be compelled to liquidate particular assets at inopportune times and at disadvantageous prices;

•

competition might prevent us from acquiring mortgage-backed securities at favorable yields, which would harm our results of operations;

•

if we are disqualified as a REIT, we will be subject to tax as a regular corporation and face substantial tax liability; and

•

complying with REIT requirements might cause us to forego otherwise attractive opportunities.

          Management has established interest rate risk and other policies for managing the portfolio of mortgage-backed securities and the related borrowings outstanding. These policies include, without limitation, evaluating the level of risk we assume when purchasing adjustable-rate or hybrid adjustable-rate mortgage-backed securities which are subject to periodic and lifetime interest rate caps, matching the interest rates on our assets and liabilities, acquiring new mortgage-backed securities to replace prepaid securities, purchasing mortgage-backed securities that we believe to have favorable-risk adjusted expected returns relative to the market interest rates at the time of purchase, borrowing between eight and 12 times the amount of our stockholders’ equity, entering into derivative transactions to protect us from rising interest rates on our repurchase agreements, and monitoring our qualification as a REIT.

          Refer to the section titled “Risk Factors” for additional discussion regarding these and other risk factors which affect our business. Refer to the section titled “Interest Rate Risk” of Item 3 of Part I, “Quantitative and Qualitative Disclosure About Market Risk,” for additional interest rate risk discussion.

Critical Accounting Policies

          Our financial statements are prepared in accordance with accounting principles generally accepted in the United States of America, or GAAP. These accounting principles require us to make some complex and subjective decisions and assessments. Our most critical accounting policies involve decisions and assessments which could significantly affect our reported assets and liabilities, as well as our reported revenues and expenses. We believe that all of the decisions and assessments upon which our financial statements are based were reasonable at the time made based upon information available to us at that time. Descriptions of the significant accounting policies of the Company are included in Note 1 to financial statements in the Company’s 2003 Annual Report on Form 10-K. There have been no significant changes to these policies during 2004. Management has identified our most critical accounting policies to be the following:

     Classifications of Investment Securities

          Our investments in mortgage-backed securities are classified as available-for-sale securities which are carried on the balance sheet at their fair value. The classification of the securities as available-for-sale results in changes in fair value being recorded as adjustments to accumulated other comprehensive loss, which is a component of stockholders’ equity, rather than immediately through earnings. If available-for-sale securities were classified as trading securities, there could be substantially greater volatility in earnings from period-to-period.

     Valuations of Mortgage-backed Securities

          Our mortgage-backed securities have fair values as determined by our Manager with reference to price estimates provided by independent pricing services and dealers in the securities. Because the price estimates may vary to some degree between sources, our Manager must make certain judgments and assumptions about the appropriate price to use to calculate the fair values for financial reporting purposes. Different judgments and assumptions could result in different presentations of value.

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          When the fair value of an available-for-sale security is less than amortized cost, management considers whether there is an other-than-temporary impairment in the value of the security. If, in management’s judgment, an other-than-temporary impairment exists, the cost basis of the security is written down to the then-current fair value, and the unrealized loss is transferred from accumulated other comprehensive loss as an immediate reduction of current earnings (as if the loss had been realized in the period of impairment). The determination of other-than-temporary impairment is a subjective process, and different judgments and assumptions could affect the timing of loss realization.

          Management considers the following factors when evaluating the securities for an other-than-temporary impairment:

•

the length of the time and the extent to which the market value has been less than the amortized cost;

•

whether the security has been downgraded by a rating agency; and

•

our intent to hold the security for a period of time sufficient to allow for any anticipated recovery in market value.

          The determination of other-than-temporary impairment is evaluated at least quarterly. If in the future management determines an impairment to be other-than-temporary we may need to realize a loss that would have an impact on future income.

     Interest Income Recognition

          Interest income on our mortgage-backed securities is accrued based on the actual coupon rate and the outstanding principal amount of the underlying mortgages. Premiums and discounts are amortized or accreted into interest income over the lives of the securities using the effective yield method adjusted for the effects of estimated prepayments based on Statement of Financial Accounting Standards, or SFAS, No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases. If our estimate of prepayments is incorrect, we may be required to make an adjustment to the amortization or accretion of premiums and discounts that would have an impact on future income.

     Accounting for Derivative Financial Instruments and Hedging Activities

          Our policies permit us to enter into derivative contracts, including Eurodollar futures contracts and interest rate swaps, as a means of mitigating our interest rate risk on forecasted interest expense associated with the benchmark rate on forecasted rollover/reissuance of repurchase agreements or the interest rate repricing of repurchase agreements, or hedged items, for a specified future time period.

          At June 30, 2004, we have engaged in short sales of Eurodollar futures contracts to mitigate our interest rate risk for the specified future time period, which is defined as the calendar quarter immediately following the contract expiration date. The value of these futures contracts is marked-to-market daily in our margin account with the custodian. Based upon the daily market value of these futures contracts, we either receive funds into, or wire funds into, our margin account with the custodian to ensure that an appropriate margin account balance is maintained at all times through the expiration of the contracts.

          At June 30, 2004, we have engaged in interest rate swap contracts to mitigate our interest rate risk for the period defined by the maturity of the swap. Cash flows that occur each time the swap is repriced are associated with forecasted interest expense for a specified future period, which is defined as the calendar period preceding each repricing date with the same number of months as the repricing frequency.

          The futures and interest rate swap contracts, or hedge instruments, have been designated as cash flow hedges and are evaluated at inception and on an ongoing basis in order to determine whether they qualify for hedge accounting under SFAS No. 133, as amended and interpreted. The hedge instrument must be highly effective in achieving offsetting changes in the hedged item attributable to the risk being hedged in order to qualify for hedge

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accounting. In order to determine whether the hedge instrument is highly effective, we use regression methodology to assess the effectiveness of our hedging strategies. Specifically, at the inception of each new hedge and on an ongoing basis, we assess effectiveness using “ordinary least squares” regression to evaluate the correlation between the rates consistent with the hedge instrument and the underlying hedged items. A hedge instrument is highly effective if the changes in the fair value of the derivative provide offset of at least 80% and not more than 120% of the changes in fair value or cash flows of the hedged item attributable to the risk being hedged. The futures and interest rate swap contracts are carried on the balance sheet at fair value. Any ineffectiveness which arises during the hedging relationship, is recognized in interest expense during the period in which it arises. Prior to the end of the specified hedge time period the effective portion of all contract gains and losses (whether realized or unrealized) is recorded in other comprehensive income or loss. Realized gains and losses on futures contracts are reclassified into earnings as an adjustment to interest expense during the specified hedge time period. Realized gains and losses on interest rate swap contracts are reclassified into earnings as an adjustment to interest expense during the period subsequent to the swap repricing date through the remaining maturity of the swap. For REIT taxable net income purposes, realized gains and losses on futures and interest rate swap contracts are reclassified into earnings immediately when positions are closed or have expired.

          We are not required to account for the futures and interest rate swap contracts using hedge accounting as described above. If we decided not to designate the futures and interest rate swap contracts as hedges and to monitor their effectiveness as hedges, or if we entered into other types of financial instruments that did not meet the criteria to be designated as hedges, changes in the fair values of these instruments would be recorded in the statement of operations, potentially resulting in increased volatility in our earnings.

     Management Incentive Compensation Expense

          The Management Agreement provides for the payment of incentive compensation to the Manager if our financial performance exceeds certain benchmarks. Incentive compensation is calculated on a cumulative, quarterly basis for GAAP purposes and on a stand-alone quarterly basis with an annual cumulative reconciliation calculation for incentive compensation payment purposes. During each quarter of the fiscal year, we will calculate the incentive compensation expense quarterly, on a cumulative basis, making any necessary adjustments for any expensed amounts that were recognized in previous quarters. As a result, if we experience poor quarterly performance in a particular quarter and this causes the cumulative incentive compensation expense for the current quarter to be lower than the cumulative incentive compensation for the prior quarter, we will record a negative incentive compensation expense in the current quarter. The incentive compensation is payable one-half in cash and one-half in the form of our restricted common stock.

          For the first, second and third quarters of each fiscal year, incentive compensation payments actually paid to the Manager are calculated based upon the net income and relevant performance thresholds solely for the applicable quarter, and a cumulative calculation is performed at the end of the fiscal year. As a result, during the first three quarters of each fiscal year there will be differences between incentive compensation expense, for GAAP purposes, and the incentive compensation amounts actually paid to the Manager. Any differences between these amounts will be reflected on the balance sheet as a receivable due from or payable due to the Manager. In addition, when each annual cumulative incentive compensation calculation and reconciliation is performed, the Manager may be required to return cash incentive compensation payments earlier received or shares of common stock earlier granted, as applicable, to it as part of its incentive compensation payments for the first three quarters of the fiscal year.

          The cash portion of the incentive compensation is accrued and expensed during the period for which it is calculated and paid. We account for the restricted stock portion of the incentive compensation in accordance with SFAS No. 123, Accounting for Stock-based Compensation, and related interpretations, and EITF 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.

          This restricted stock portion of the incentive compensation will be granted to the Manager on a quarterly basis pursuant to the terms of the Management Agreement. The number of shares issued is based on (a) one-half of the total incentive compensation for the period, divided by (b) the average of the closing prices of the common stock

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over the 30-day period ending three calendar days prior to the grant date, less a fair market value discount determined by our board of directors to account for the transfer restrictions during the vesting period. During periods of lower stock prices, we will issue more restricted common stock to the Manager under the Management Agreement to pay for the same amount of incentive compensation earned in periods that had higher stock prices. Over the vesting period, any additional shares issued would have a dilutive effect on book value and net income per share.

          On the date of each restricted stock grant to the Manager under the Management Agreement, the fair market value of the common stock is recorded in the stockholders’ equity section of our balance sheet as common stock and additional paid-in capital. The corresponding portion of any restricted stock grant that is not expensed is reflected in the stockholders’ equity section of our balance sheet as deferred compensation. Each quarter’s incentive compensation restricted stock grant to the Manager is divided into three tranches. The first tranche will vest over a one-year period and be expensed over a five-quarter period, beginning in the quarter in which it was earned. The second tranche will vest over a two-year period and be expensed over a nine-quarter period beginning in the quarter in which it was earned. The third tranche will vest over a three-year period and be expensed over a thirteen-quarter period beginning in the quarter in which it was earned. As a result of this vesting schedule for the restricted stock granted to the Manager, we will incur incentive compensation expense in each of the periods following the grant of the restricted stock over a three-year period. We will continue to incur incentive compensation expense related to each restricted stock grant, even in subsequent periods in which the Manager did not earn incentive compensation under the Management Agreement.

          As the price of our common stock changes in future periods, the fair value of the unvested portions of shares paid to the Manager pursuant to the Management Agreement shall be marked-to-market, with corresponding entries on the balance sheet. The net effect of any mark-to-market adjustments to the value of the unvested portions of the restricted stock shall be expensed in future periods, on a ratable basis, according to the remaining vesting schedules of each respective tranche of restricted common stock. Accordingly, incentive compensation expense related to the portion of the incentive compensation paid to the Manager in each restricted stock grant may be higher or lower from one reporting period to the next, and may vary throughout the vesting period. For example, future incentive compensation expense related to previously issued but unvested restricted stock will be higher during periods of increasing stock prices, and lower during periods of decreasing stock prices. In addition, over the vesting period for each restricted stock grant, our stockholders’ equity will increase or decrease based upon the current market price of our stock. As a result, this will have the effect of increasing or decreasing our net worth, the factor used in calculating the Manager’s base management fee, and may increase or decrease the amount of base management fees in future periods.

          Pursuant to the Management Agreement, it is possible for the Manager to earn incentive compensation each quarter and, as a result, receive a restricted stock grant each quarter. As the Manager is granted multiple tranches of restricted common stock for incentive compensation, we will experience increasing management fee expense due to the cumulative impact of multiple tranches and vesting schedules of restricted stock grants, and the mark-to-market impact of the unvested portions of these grants. This will be true even in periods where there is little change in our income or stock price.

          We also pay an incentive fee, in the form of cash and restricted stock, to our Chief Financial Officer, in accordance with the terms of his employment agreement. The incentive fee is accounted for in the same manner as the incentive fee earned by the Manager.

Recent Accounting Pronouncements

          In March 2004, the Emerging Issues Task Force, or EITF, reached a consensus on Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. This Issue provides clarification with respect to the meaning of other-than-temporary impairment and its application to investments classified as either available-for-sale or held-to-maturity under Statement of Financial Accounting Standard, or SFAS, No. 115, Accounting for Certain Investments in Debt and Equity Securities, (including individual securities and investments in mutual funds), and investments accounted for under the cost method or the equity method. The guidance for evaluating whether an investment is other-than-temporarily impaired must be applied in other-than-

25

temporary impairment evaluations made in reporting periods beginning after June 15, 2004. This Issue did not have a material impact on the Company’s financial statements.

Financial Condition

     Mortgage-Backed Securities

          At June 30, 2004, we held $4.2 billion of mortgage-backed securities at fair value, net of unrealized gains of $276 thousand and unrealized losses of $87.2 million. At December 31, 2003, we held $2.2 billion of mortgage-backed securities at fair value, net of unrealized gains of $1.1 million and unrealized losses of $27.4 million. The increase in mortgage-backed securities held is primarily the result of the public offering which was completed on March 29, 2004. At June 30, 2004 and December 31, 2003, all of the mortgage-backed securities in our portfolio were purchased at a premium to their par value and our portfolio had a weighted-average amortized cost of 101.8% and 102.2% of face amount, respectively.

          Fair value was below amortized cost for certain of the securities held at June 30, 2004 and December 31, 2003. At June 30, 2004 and December 31, 2003, our entire portfolio was invested in AAA-rated non-agency-backed or agency-backed mortgage-backed securities. None of the securities held had been downgraded by a credit rating agency since their purchase. In addition, we intend to hold the securities until maturity, allowing for the anticipated recovery in fair value of the securities held. As such, we do not believe any of the securities held are other-than-temporarily impaired at June 30, 2004 and December 31, 2003.

          The stated contractual final maturity of the mortgage loans underlying our portfolio of mortgage-backed securities ranges up to 30 years, however, the expected maturities are subject to change based on the prepayments of the underlying mortgage loans. The following table sets forth the maturity dates, by year, and percentage composition related to the assets that comprise our investment portfolio at June 30, 2004:

          The following table sets forth the maturity dates, by year, and percentage composition related to the assets that comprise our investment portfolio at December 31, 2003:

          Actual maturities of mortgage-backed securities are generally shorter than stated contractual maturities. Actual maturities of our mortgage-backed securities are affected by the contractual lives of the underlying mortgages, periodic payments of principal, and prepayments of principal.

          The principal payment rate on our mortgage-backed securities, an annual rate of principal paydowns for our mortgage-backed securities relative to the outstanding principal balance of our mortgage-backed securities, was 33% and 28% for the three and six months ended June 30, 2004, respectively. The principal payment rate for the period from April 26, 2003 through June 30, 2003 is considered not meaningful as the Company was organized on April 25, 2003 and substantive operations did not begin until mid-June 2003. The principal payment rate attempts to predict the percentage of principal that will paydown over the next 12 months based on historical principal paydowns. The principal payment rate for the second quarter of 2004 increased in comparison to the first quarter of

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2004 primarily due to the residual effects of the lower interest rate environment in the first quarter of 2004. By June 30, 2004 the residual effects of the lower interest rate environment had weakened, resulting in a principal payment rate of 28% for the month ended June 30, 2004.

          At June 30, 2004 and December 31, 2003, the weighted-average effective duration of the securities in our overall investment portfolio, assuming constant prepayment rates, or CPR, to the balloon or reset date, or the CPB duration, was 2.12 years and 1.75 years, respectively. CPR is a measure of the rate of prepayment for our mortgage-backed securities, expressed as an annual rate relative to the outstanding principal balance of our mortgage-backed securities. CPB is similar to CPR except that it also assumes that the hybrid adjustable-rate mortgage-backed securities prepay in full at their next reset date. At June 30, 2004 and December 31, 2003, the mortgages underlying our hybrid adjustable-rate mortgage-backed securities had fixed interest rates for a weighted-average of approximately 41 months and 43 months, respectively, after which time the interest rates reset and become adjustable. The average length of time until maturity of those mortgages was 30 years. Those mortgages are also subject to interest rate caps that limit the amount that the applicable interest rate can increase during any year, known as an annual cap, and through the maturity of the applicable security, known as a lifetime cap. At June 30, 2004 and December 31, 2003, the mortgages underlying our hybrid adjustable-rate mortgage-backed securities had average annual caps of 2.34% and 2.47%, respectively, and average lifetime caps of 9.90% and 10.03%, respectively.

          The following table summarizes our mortgage-backed securities at June 30, 2004, according to their estimated weighted-average life classifications:

          The following table summarizes our mortgage-backed securities at December 31, 2003 according to their estimated weighted-average life classifications:

          The weighted-average lives of the mortgage-backed securities at June 30, 2004 and December 31, 2003 in the tables above are based upon data provided through a subscription-based financial information service provided by a major investment bank, assuming constant principal prepayment rates to the balloon or reset date for each security. At June 30, 2004 and December 31, 2003, the weighted-average lives were calculated using estimated prepayment speeds or actual prepayment speed history. The weighted-average lives for some of the mortgage-backed securities included in the table above were estimated using expected prepayment speeds for pools, since certain pools were new issues and did not have historical performance data available. The prepayment model considers current yield, forward yield, steepness of the yield curve, current mortgage rates, the mortgage rate of the outstanding loan, loan age, margin and volatility.

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          The actual weighted-average lives of the mortgage-backed securities in our investment portfolio could be longer or shorter than the estimates in the tables above depending on the actual prepayment rates experienced over the life of the applicable securities and is sensitive to changes in both prepayment rates and interest rates.

     Equity Securities

          Our investment policies allow us to acquire a limited amount of equity securities, including common and preferred shares issued by other real estate investment trusts. At June 30, 2004 and December 31, 2003, we did not hold any such equity securities.

     Unsettled Securities Purchases

          At June 30, 2004, we had no unsettled security trades. At December 31, 2003, we had unsettled securities purchases of $156.1 million. Of the $156.1 million of unsettled securities purchases at December 31, 2003, $59.8 million were related to “to be announced,” or TBA, mortgage-backed securities.

     Other Assets

          We had other assets of $32.3 million and $10.2 million at June 30, 2004 and December 31, 2003, respectively. Other assets at June 30, 2004 consist primarily of interest receivable of $15.9 million, principal receivable of $14.9 million, prepaid directors and officers liability insurance of $411 thousand and deferred compensation of $825 thousand. Other assets at December 31, 2003 consist primarily of interest receivable of $7.3 million and principal receivable of $2.3 million.

     Hedging Instruments

          Hedging involves risk and typically involves costs, including transaction costs. The costs of hedging can increase as the period covered by the hedging increases and during periods of rising and volatile interest rates. We may increase our hedging activity and, thus, increase our hedging costs during such periods when interest rates are volatile or rising. We generally intend to hedge as much of the interest rate risk as our Manager determines is in the best interest of our stockholders, after considering the cost of such hedging transactions and our desire to maintain our status as a REIT. Our policies do not contain specific requirements as to the percentages or amount of interest rate risk that our Manager is required to hedge. There can be no assurance that our hedging activities will have the desired beneficial impact on our results of operations or financial condition. Moreover, no hedging activity can completely insulate us from the risks associated with changes in interest rates and prepayment rates.

          At June 30, 2004 and December 31, 2003, we have engaged in short sales of Eurodollar futures contracts as a means of mitigating our interest rate risk on forecasted interest expense associated with the benchmark rate on forecasted rollover/reissuance of repurchase agreements or the interest rate repricing of repurchase agreements, or hedged item, for a specified future time period, which is defined as the calendar quarter immediately following the contract expiration date. At June 30, 2004, we had short positions on 9,850 Eurodollar futures contracts, which expire in September 2004, December 2004, March 2005 and June 2005, with a notional amount totaling $9.9 billion. At December 31, 2003, we had short positions on 2,090 Eurodollar futures contracts, which expire in June 2004, September 2004, and December 2004, with a notional amount totaling $2.1 billion. The value of these futures contracts is marked-to-market daily in our margin account with the custodian. Based upon the daily market value of these futures contracts, we either receive funds into, or wire funds into, our margin account with the custodian to ensure that an appropriate margin account balance is maintained at all times through the expiration of the contracts. At June 30, 2004 and December 31, 2003, the fair value of the Eurodollar futures contracts was $9.2 million recorded in assets and $157 thousand recorded in liabilities, respectively.

          At June 30, 2004, we have engaged in interest rate swap contracts to mitigate our interest rate risk for the period defined by maturity of the interest rate swap. Cash flows that occur each time the swap is repriced are associated with forecasted interest expense for a specified future period, which is defined as the calendar period preceding each repricing date with the same number of months as the repricing frequency. At June 30, 2004, the

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current notional amount of interest rate swap contracts totaled $1.0 billion and the fair value of the interest rate swap contracts was $4.1 million. There were no interest rate swap contracts at December 31, 2003.

     Liabilities

          We have entered into repurchase agreements to finance some of our acquisitions of mortgage-backed securities. None of the counterparties to these agreements are affiliates of the Manager or us. These agreements are secured by our mortgage-backed securities and bear interest rates that have historically moved in close relationship to LIBOR. At June 30, 2004, we had established 18 borrowing arrangements with various investment banking firms and other lenders, 14 of which were in use at June 30, 2004.

          At June 30, 2004, we had outstanding $3.8 billion of repurchase agreements with a weighted-average current borrowing rate of 1.31%, $322.5 million of which matures within 30 days, $2.1 billion of which matures between 31 and 90 days, and $1.4 billion of which matures in greater than 90 days. At December 31, 2003, we had outstanding $1.7 billion of repurchase agreements with a weighted-average current borrowing rate of 1.19%, $337.3 million of which matures within 30 days, $281.9 million of which matures between 31 and 90 days, and $1.1 billion of which matures in greater than 90 days. The increase in outstanding repurchase agreements is primarily due to the public offering which was completed on March 29, 2004. We used the net proceeds of that follow-on equity offering to purchase mortgage-backed securities through leverage. It is our present intention to seek to renew the repurchase agreements outstanding at June 30, 2004 as they mature under the then-applicable borrowing terms of the counterparties to our repurchase agreements. At June 30, 2004 and December 31, 2003, the repurchase agreements were secured by mortgage-backed securities with an estimated fair value of $4.1 billion and $1.8 billion, respectively, and had a weighted-average maturity of 169 days and 145 days, respectively. The net amount at risk, defined as the sum of the fair value of securities sold plus accrued interest income minus the sum of repurchase agreement liabilities plus accrued interest expense, with all counterparties was $239.9 million and $83.2 million at June 30, 2004 and December 31, 2003, respectively.

          After consideration of the terms of our Eurodollar futures and interest rate swap contracts, the weighted-average maturity of our total liabilities was 383 days and 255 days at June 30, 2004 and December 31, 2003, respectively. The increase in the weighted-average maturity of our total liabilities is primarily attributed to the use of interest rate swap contracts during the three months ended June 30, 2004 to hedge the impact of changes in interest rates on our liability costs.

          We had $29.8 million and $167.9 million of other liabilities at June 30, 2004 and December 31, 2003, respectively. Other liabilities at June 30, 2004 consisted primarily of $15.9 million of cash distribution payable, $7.6 million of accrued interest expense on repurchase agreements, $3.1 million of management fees payable, incentive fees payable and other related party liabilities, and $2.6 million of collateral held from counterparties. Other liabilities at December 31, 2003, consisted primarily of $156.1 million of unsettled securities purchases, $5.3 million of cash distribution payable, $3.8 million of accrued interest expense on repurchase agreements, and $2.5 million of management fee payable, incentive fees payable and other related party liabilities.

          We have a margin lending facility with our primary custodian from which we may borrow money in connection with the purchase or sale of securities. The terms of the borrowings, including the rate of interest payable, are agreed to with the custodian for each amount borrowed. Borrowings are repayable immediately upon demand by the custodian. At June 30, 2004 and December 31, 2003, there were no outstanding borrowings under the margin lending facility.

     Stockholders’ Equity

          Stockholders’ equity at June 30, 2004 and December 31, 2003 was $393.2 million and $282.5 million, respectively, which included $86.9 million and $26.3 million, respectively, of unrealized losses on mortgage-backed securities available-for-sale and $13.8 million and ($157) thousand, respectively, of net deferred realized and unrealized gains/(losses) on cash flow hedges presented as accumulated other comprehensive loss.

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          Weighted-average stockholders’ equity and return on average equity for the three and six months ended June 30, 2004 were $412.7 million and 14.58%, and $357.6 million and 14.48%, respectively. Return on average equity is defined as annualized net income divided by weighted-average stockholders’ equity.

          Weighted-average stockholders’ equity and return on average equity for the period from April 26, 2003 through June 30, 2003 is considered not meaningful as the Company was organized on April 25, 2003 and substantive operations did not begin until mid-June 2003.

          Our book value at June 30, 2004 was as follows:

(1)

Based on 36,900,193 shares outstanding at June 30, 2004

          Our book value at December 31, 2003 was as follows:

(1)

Based on 24,814,000 shares outstanding at December 31, 2003

          Management believes that total stockholders’ equity, excluding accumulated other comprehensive income and loss on mortgage-backed securities and interest rate swap contracts, is a useful measure to investors because book value unadjusted for temporary changes in fair value more closely represents the cost basis of our invested assets, net of our leverage, which is the basis for our net interest income and our distributions to stockholders under the provisions of the Internal Revenue Code governing REIT distributions.

Results of Operations

          For the three months ended June 30, 2004, net income was $15.0 million or $0.41 per weighted-average share outstanding (basic and diluted). For the same period, interest income, net of premium amortization, was approximately $27.2 million, and was primarily earned from investments in mortgage-backed securities. On March 29, 2004, we completed a public offering of 12,000,000 shares of common stock. Interest income during the three months ended June 30, 2004 reflects the impact of this public offering, however, a substantial portion of the securities purchased as a result of the public offering were not settled for the full three month period. As such, interest income is lower than would be expected for a full quarterly period. Prepayment activity increased during the

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