Anworth Mortgage Asset 10Q 2003 Q3 Quarterly report

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

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

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2003

Commission File Number: 001-13709

ANWORTH MORTGAGE ASSET

CORPORATION

(Exact Name of Registrant as Specified in Its Charter)

MARYLAND		52-2059785
(State or other jurisdiction of Incorporation or organization)		(I.R.S. Employer Identification No.)

1299 Ocean Avenue, #250, Santa Monica, California		90401
(Address of principal executive offices)		(Zip Code)

Registrant’s telephone number, including area code: (310) 255-4493

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 Act). Yes x No ¨

As of November 12, 2003, the Registrant had 39,190,050 shares of Common Stock outstanding.

ANWORTH MORTGAGE ASSET CORPORATION

FORM 10-Q

INDEX

			Page

Part I.		FINANCIAL INFORMATION	1

	Item 1.	Financial Statements	1

		Balance Sheets as of September 30, 2003 and December 31, 2002	1

		Statements of Operations for the three and nine months ended September 30, 2003 and 2002	2

		Statements of Stockholders’ Equity for the three months ended March 31, 2003, June 30, 2003 and September 30, 2003	3

		Statements of Cash Flows for the three and nine months ended September 30, 2003 and 2002	4

		Notes To Unaudited Financial Statements	5

	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	16

	Item 3.	Qualitative and Quantitative Disclosures About Market Risk	34

	Item 4.	Controls and Procedures	37

Part II.		OTHER INFORMATION	38

	Item 1.	Legal Proceedings	38

	Item 2.	Changes in Securities and Use of Proceeds	38

	Item 3.	Defaults Upon Senior Securities	38

	Item 4.	Submission of Matters to a Vote of Security Holders	38

	Item 5.	Other Information	38

	Item 6.	Exhibits and Reports on Form 8-K	38

	Signatures		41

Part I. FINANCIAL INFORMATION

Item 1. Financial Statements

ANWORTH MORTGAGE ASSET CORPORATION

BALANCE SHEETS

(in thousands)

(unaudited)

	September 30, 2003			December 31, 2002
ASSETS
Mortgage-backed securities:
Mortgage-backed securities pledged to counterparties at fair value	$	3,440,600		$	2,338,405
Mortgage-backed securities at fair value		269,263			91,698

		3,709,863		$	2,430,103
Cash and cash equivalents		116			906
Interest receivable		14,932			11,673
Prepaid expenses and other		347			1,202

	$	3,725,258		$	2,443,884

LIABILITIES AND STOCKHOLDERS’ EQUITY
Liabilities
Reverse repurchase agreements	$	3,291,734		$	2,153,870
Payable for purchase of mortgage-backed securities		14			—
Accrued interest payable		10,095			9,944
Dividends payable		—			12,673
Accrued expenses and other		996			1,875

		3,302,839			2,178,362

Stockholders’ Equity
Preferred stock, par value $.01 per share; authorized 20,000 shares; no shares issued and outstanding		—			—
Common stock, par value $.01 per share; authorized 100,000 shares; 38,274 and 25,396 issued and 38,274 and 25,346 outstanding respectively		383			253
Additional paid in capital		430,014			256,610
Accumulated other comprehensive (loss) income consisting of unrealized (losses) gains on available-for-sale securities		(10,510	)		14,860
Retained earnings (deficit)		3,227			(5,218	)
Unearned restricted stock		(695	)		(754	)
Treasury stock at cost (50 shares) at December 31, 2002		0			(229	)

		422,419			265,522

	$	3,725,258		$	2,443,884

See accompanying notes to financial statements.

ANWORTH MORTGAGE ASSET CORPORATION

STATEMENTS OF OPERATIONS

(in thousands, except for per share amounts)

(unaudited)

	Three months ended September 30,						Nine months ended September 30,
	2003			2002			2003			2002
Interest income net of amortization of premium and discount	$	22,774		$	23,134		$	70,471		$	43,276
Interest expense		(11,647	)		(10,469	)		(32,660	)		(18,590	)

Net interest income		11,127			12,665			37,811			24,686

Gain on sale of securities		706			1,838			3,497			3,493
Expenses:
External base management fee		—			—			—			(400	)
External incentive fee		—			—			—			(1,741	)
Compensation and benefits		(348	)		(189	)		(1,095	)		(207	)
Incentive compensation		(622	)		(1,428	)		(3,028	)		(1,751	)
Cost incurred in acquiring external manager (Note 4)		—			(295	)		—			(3,475	)
Other expenses		(496	)		(490	)		(1,424	)		(700	)

Total expenses		(1,466	)		(2,402	)		(5,547	)		(8,274	)

Net income	$	10,367		$	12,101		$	35,761		$	19,905

Basic earnings per share	$	0.29		$	0.52		$	1.18		$	1.32

Average number of shares outstanding		35,368			23,336			30,381			15,112

Diluted earnings per share	$	0.29		$	0.52		$	1.17		$	1.31

Average number of diluted shares outstanding		35,618			23,433			30,591			15,192

Dividends declared per share	$	0.45		$	0.50		$	0.90		$	1.50

See accompanying notes to financial statements.

ANWORTH MORTGAGE ASSET CORPORATION

STATEMENT OF STOCKHOLDERS’ EQUITY

(in thousands)

(unaudited)

	Common Stock Shares		Common Stock Par Value		Additional Paid-in Capital			Accum. Other Compre- hensive Income (Loss)			Retained Earnings (Deficit)			Unearned Restricted Stock				Treasury Stock at Cost			Compre- hensive Income		Total
Balance, December 31, 2002		25,346	$	253	$	256,610		$	14,860		$	(5,218	)	$	(754	)		$	(299	)			$	265,522
Issuance of common stock		1,213		12		14,623																		14,635
Available-for-sale securities, fair value adjustment									836												836			836
Net income												11,822									11,822			11,822
																	��
Total comprehensive income																					12,658

Amortization of restricted stock															20									20

Balance, March 31, 2003		26,559		265		271,233			15,696			6,604			(734	)			(229	)				292,835

Issuance of common stock		6,269		63		83,106																		83,169
Available-for-sale securities, fair value adjustment									(9,327	)											(9,327	)		(9,327	)
Net income												13,572									13,572			13,572

Total comprehensive income																					4,245

Amortization of restricted stock															19									19
Dividends declared – 0.45/share												(12,358	)											(12,358	)

Balance, June 30, 2003		32,828		328		354,339			6,369			7,818			(715	)			(229	)				367,910

Issuance of common stock		5,446		55		75,904																		75,959
Retired Treasury Stock						(229	)												229					—
Available-for-sale securities, fair value adjustment									(16,879	)											(16,879	)		(16,879	)
Net income												10,367									10,367			10,367

Total comprehensive loss																					(6,512	)

Amortization of restricted stock															20									20
Dividends declared – 0.45/share												(14,958	)											(14,958	)

Balance, September 30, 2003	$	38,274	$	383	$	430,014		$	(10,510	)	$	3,227		$	(695	)		$	—				$	422,419

See accompanying notes to financial statements.

ANWORTH MORTGAGE ASSET CORPORATION

STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

	For the three months ended September 30,						For the nine months ended September 30,
	2003			2002			2003			2002
Operating Activities:
Net income	$	10,367		$	12,101		$	35,761		$	19,905
Adjustments to reconcile net income to net cash provided by operating activities
Amortization of premiums and discounts		13,439			4,314			29,459			8,179
Gain on sales		(706	)		(1,838	)		(3,497	)		(3,493	)
Non-cash portion of cost incurred in acquiring exernal manager		—			249			—			3,429
Amortization of restricted stock		20			—			59			—
Increase in interest receivable		(1,054	)		(3,185	)		(3,259	)		(10,008	)
Decrease (Increase) in prepaid expenses and other		329			(136	)		856			(170	)
(Decrease) Increase in accrued interest payable		(753	)		3,515			151			6,404
(Decrease) Increase in accrued expenses and other		(558	)		(1	)		(879	)		1,007

Net cash provided by operating activities		21,084			15,019			58,651			25,253
Investing Activities:
Available-for-sale securities:
Purchases		(904,595	)		(1,022,745	)		(2,632,180	)		(2,546,974	)
Proceeds from sales		31,272			161,683			174,879			270,744
Principal payments		507,362			161,882			1,126,222			293,690

Net cash used in investing activities		(365,961	)		(699,180	)		(1,331,079	)		(1,982,540	)
Financing Activities:
Net borrowings from reverse repurchase agreements		283,726			663,810			1,137,864			1,788,040
Proceeds from common stock issued, net		75,759			13,980			173,763			182,938
Dividends paid		(14,958	)		(6,269	)		(39,989	)		(13,697	)

Net cash provided by financing activities		344,727			671,521			1,271,638			1,957,281

Net decrease in cash and cash equivalents		(150	)		(12,640	)		(790	)		(6	)
Cash and cash equivalents at beginning of period		266			12,924			906			290

Cash and cash equivalents at end of period	$	116		$	284		$	116		$	284

Supplemental Disclosure of Cash Flow Information:
Cash paid for interest	$	12,400		$	4,388		$	32,509		$	12,186
Supplemental Disclosure of Investing and Financing Activities:
Mortgage securities purchased, not yet settled	$	—		$	—		$	—		$	—
Common stock issued to acquire external manager	$	—		$	—	��	$	—		$	3,180
Restricted stock issued	$	—		$	—		$	—		$	794
Retirement of Treasury Stock	$	229		$	—		$	229		$	—

See accompanying notes to financial statements.

ANWORTH MORTGAGE ASSET CORPORATION

NOTES TO UNAUDITED FINANCIAL STATEMENTS

NOTE 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES

Anworth Mortgage Asset Corporation (the “Company”) was incorporated in Maryland on October 20, 1997. The Company commenced its operations of purchasing and managing an investment portfolio of primarily mortgage-backed securities (“MBS”) on March 17, 1998, upon completion of its initial public offering of the Company’s common stock.

The Company has elected to be taxed as a real estate investment trust (“REIT”) for federal income tax purposes. Pursuant to current federal tax regulations, one of the requirements of maintaining its status as a REIT is that the Company must distribute at least 90% of its annual taxable net income to its stockholders, subject to certain adjustments.

From the time of its inception through June 13, 2002, the Company was externally managed by Anworth Mortgage Advisory Company (the “Manager”), pursuant to a management agreement between the parties (the “Management Agreement”). As an externally managed company, the Company had no employees of its own and relied on the Manager to conduct its business and operations.

On June 13, 2002, the Manager merged with and into the Company (the “Merger”). The Merger was approved by a special committee consisting solely of the Company’s independent directors, the Company’s full board of directors and the vote of a majority of the Company’s stockholders. Upon the closing of the Merger, the Management Agreement terminated.

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

Basis of Presentation

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

In the opinion of management, all material adjustments, consisting of normal recurring adjustments, considered necessary for a fair presentation have been included. The operating results for the quarter ended September 30, 2003 are not necessarily indicative of the results that may be expected for the calendar year ending December 31, 2003.

Cash and Cash Equivalents

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

Mortgage-Backed Securities (“MBS”)

The Company has invested primarily in fixed-rate and adjustable-rate mortgage (“ARM”) pass-through certificates and hybrid ARM securities. Hybrid ARM securities have an initial interest rate that is fixed for a certain period, usually three to five years, and then adjust annually for the remainder of the term of the loan.

The Company classifies its investments as either trading investments, available-for-sale investments or held-to-maturity investments. Management determines the appropriate classification of the securiteis at the time they

ANWORTH MORTGAGE ASSET CORPORATION

NOTES TO UNAUDITED FINANCIAL STATEMENTS—(Continued)

are acquired and evaluates the appropriateness of such classifications at each balance sheet date. The Company currently classifies all of its securities as available-for-sale. All assets that are classified as available-for-sale are carried at fair value and unrealized gains or losses are included in other comprehensive income or loss as a component of stockholders’ equity. Losses on securities classified as available-for-sale which are determined by management to be other than temporary in nature are reclassified from accumulated other comprehensive income to current operations.

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

Securities are recorded on the date the securities are purchased or sold (the trade date). Realized gains or losses from securities transactions are determined based on the specific identified cost of the securities.

Derivative Financial Instruments

The Company periodically enters into derivative transactions, in the form of forward purchase commitments, which are intended to hedge its exposure to rising interest rates on funds borrowed to finance its investments in securities. The Company has designated these transactions as cash flow hedges. The Company also enters into derivative transactions also in the form of forward purchase commitments, which are not designated as hedges.

When the Company enters into hedging transactions, it formally documents the relationship between the hedging instruments and the hedged items. The Company also documents its risk-management policies, including objectives and strategies, as it relates to its hedging activities. The Company assesses, both at inception of the hedging activity and on an on-going basis, whether or not the hedging activity is highly effective. When it is determined that a hedge is not highly effective, the Company discontinues hedge accounting prospectively. As of September 30, 2003, the Company had no derivative instruments outstanding.

Credit Risk

At September 30, 2003, the Company had limited its exposure to credit losses on its portfolio of mortgage-backed securities by purchasing primarily securities from Federal Home Loan Mortgage Corporation (“FHLMC”) and Federal National Mortgage Association (“FNMA”). The payment of principal and interest on the FHLMC and FNMA MBS securities are guaranteed by those respective agencies. At September 30, 2003, over 99.9% of the Company’s mortgage-backed securities had an implied “AAA” rating.

Income Taxes

The Company has elected to be taxed as a REIT and to comply 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 to the extent that its distributions to stockholders satisfy the REIT requirements and certain asset, income and stock ownership tests are met.

Stock Based Compensation

The Company accounts for stock-based compensation using the intrinsic method prescribed by Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“FAS 123”). The Company follows the disclosure requirements of FAS 123 in “Note 5”.

ANWORTH MORTGAGE ASSET CORPORATION

NOTES TO UNAUDITED FINANCIAL STATEMENTS—(Continued)

Earnings Per Share

Basic earnings per share (“EPS”) is computed by dividing net income by the weighted average number of common shares outstanding during the period. Diluted EPS assumes the conversion, exercise or issuance of all potential common stock equivalents unless the effect is to reduce a loss or increase the income per share.

The computation of EPS is as follows (amounts in thousands, except per share data):

	Income		Average Shares	Earnings Per Share
For the three months ended September 30, 2003
Basic EPS	$	10,367	35,368	$	0.29
Effect of dilutive securities: Stock options			250

Diluted EPS	$	10,367	35,618	$	0.29

For the three months ended September 30, 2002
Basic EPS	$	12,101	23,336	$	0.52
Effect of dilutive securities: Stock options			97

Diluted EPS	$	12,101	23,433	$	0.52


	Income		Average Shares	Earnings Per Share
For the nine months ended September 30, 2003
Basic EPS	$	35,761	30,381	$	1.18
Effect of dilutive securities: Stock options			210		(0.01	)

Diluted EPS	$	35,761	30,591	$	1.17

For the nine months ended September 30, 2002
Basic EPS	$	19,905	15,112	$	1.32
Effect of dilutive securities: Stock options			80		(0.01	)

Diluted EPS	$	19,905	15,192	$	1.31

Use of Estimates

The preparation of financial statements in conformity with generally accepted accounting principles in the United States of America 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.

Recent Accounting Pronouncement

In November 2002, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation (“FIN”) No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others”. FIN No. 45 clarifies the requirements relating to the guarantor’s accounting for, and disclosure of, the issuance of certain types of guarantees. The disclosure provisions of FIN No. 45 were effective for financial statements of periods that end after December 15, 2002, and the required disclosures are included in these notes to consolidated financial statements. The provisions for initial recognition

ANWORTH MORTGAGE ASSET CORPORATION

NOTES TO UNAUDITED FINANCIAL STATEMENTS—(Continued)

and measurement are effective on a prospective basis for guarantees that are issued or modified after December 31, 2002. Adoption has not had a material impact on the Company’s results of operations and financial position.

In December 2002, the FASB issued Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure” (“FAS 148”). FAS 148 amends FAS 123 by providing alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, FAS 148 amends the disclosure requirements of FAS 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. FAS 148 is not expected to have a significant impact on the Company.

In January 2003, the FASB issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities–an interpretation of ARB No. 51” (“FIN 46”) in an effort to improve financial reporting by achieving more consistent application of consolidation policies to variable interest entities (“VIEs”). VIEs, as defined in FIN 46, were often referred to as special purpose entities in the past. In general, VIEs lack substantial equity or substance as an equity. Their risks and returns generally inure to those other than the holders of the VIE’s equity (who are referred to as “primary beneficiaries”). VIEs are required to be consolidated by their primary beneficiaries. As of September 30, 2003, the Company did not have any interests in VIEs and does not believe that the provisions of FIN 46 will have a material effect on the Company’s financial statements.

In May 2003, the FASB issued Financial Accounting Standards No.150 “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” in an effort to establish standards for classification and measurements of those financial instruments. It requires that an issuer classify a financial instrument within its scope as a liability. Many of those instruments, as stated in FAS 150, were previously classified as equity. This statement is effective at the beginning of the first interim period commencing after June 15, 2003. The provisions of FAS 150 did not have a material effect on the Company’s financial statements.

NOTE 2. MORTGAGE-BACKED SECURITIES

The following table summarizes the Company’s mortgage-backed securities classified as available-for-sale as of September 30, 2003, which are carried at their fair value (amounts in thousands):

	Government National Mortgage Corporation			Federal Home Loan Mortgage Corporation			Federal National Mortgage Association			Total MBS Assets
Amortized cost	$	203,050		$	797,288		$	2,690,815		$	3,691,153
Paydowns receivable		—			29,220			—			29,220
Unrealized gains		287			1,437			5,773			7,497
Unrealized losses		(1,279	)		(3,487	)		(13,241	)		(18,007	)

Fair value	$	202,058		$	824,458		$	2,683,347		$	3,709,863

ANWORTH MORTGAGE ASSET CORPORATION

NOTES TO UNAUDITED FINANCIAL STATEMENTS—(Continued)

The following table summarizes the Company’s securities at their fair value as of September 30, 2003 and December 31, 2002 (amounts in thousands):

September 30, 2003

	ARMs			Hybrids			Fixed			Floating Rate CMO			Total
Amortized cost	$	1,016,074		$	2,232,683		$	406,822		$	35,574		$	3,691,153
Paydowns receivable		8,091			21,129			—			—			29,220
Unrealized gains		1,289			4,056			2,123			29			7,497
Unrealized losses		(4,132	)		(9,629	)		(4,010	)		(236	)		(18,007	)

Fair value	$	1,021,322		$	2,248,239		$	404,935		$	35,367		$	3,709,863

December 31, 2002

	ARMs			Hybrids			Fixed		Floating Rate CMO		Total
Amortized cost	$	954,505		$	1,110,088		$	333,381	$	—	$	2,397,974
Paydowns receivable		8,960			8,309			—		—		17,269
Unrealized gains		2,235			8,420			5,393		—		16,048
Unrealized losses		(1,030	)		(158	)		—		—		(1,188	)

Fair value	$	964,670		$	1,126,659		$	338,774	$	—	$	2,430,103

During the three months ended September 30, 2003, the Company sold approximately $30.5 million of its available-for-sale MBS for a net realized gain of approximately $0.7 million.

During the three months ended September 30, 2002, the Company sold approximately $107 million of its available-for-sale MBS for a net realized gain of approximately $1.8 million.

NOTE 3. REVERSE REPURCHASE AGREEMENTS

The Company has entered into reverse repurchase agreements to finance most of its MBS. The reverse repurchase agreements are short-term borrowings that are secured by the market value of the Company’s MBS and bear interest rates that have historically moved in close relationship to London Interbank Offer Rate (“LIBOR”). At September 30, 2003, the Company’s reverse repurchase agreements had a weighted average term to maturity of 276 days and a weighted average borrowing rate of 1.48%. At September 30, 2003, MBS with a carrying value of approximately $3.44 billion have been pledged as collateral under the reverse repurchase agreements.

At September 30, 2003, the repurchase agreements had the following remaining maturities:

Less than 3 months	7.1	%
3 months to less than 1 year	77.3	%
1 year to less than 2 years	15.6	%
2 years to less than 3 years	—	%
Greater than 3 years	—	%

	100	%

ANWORTH MORTGAGE ASSET CORPORATION

NOTES TO UNAUDITED FINANCIAL STATEMENTS—(Continued)

NOTE 4. TRANSACTIONS WITH AFFILIATES

Management Fees and Merger with the Manager

From the time of its inception through June 13, 2002, the Company was externally managed by the Manager pursuant to the Management Agreement. As an externally managed company, the Company had no employees of its own and relied on the Manager to conduct its business and operations.

Under the terms of the Management Agreement, the Company paid the Manager an annual base management fee equal to 1% of the first $300 million of average net invested assets (as defined in the Management Agreement), plus 0.8% of the portion above $300 million. In addition to the base management fee, the Manager received as incentive compensation for each fiscal quarter an amount equal to 20% of the amount of taxable net income of the Company, before incentive compensation, for such fiscal quarter in excess of the amount that would produce an annualized return on equity (calculated by multiplying the return on equity for such fiscal quarter by four) equal to the Ten-Year U.S. Treasury Rate for such fiscal quarter plus 1%. For the quarter ended June 30, 2002, the Company paid the Manager $208,000 in base management fees. The Company paid the Manager $728,000 in incentive compensation for the quarter ended June 30, 2002.

On June 13, 2002, the Manager merged with and into the Company pursuant to the Merger. The stockholder of the Manager, a trust controlled by Lloyd McAdams, the Company’s President, Chairman and Chief Executive Officer, and Heather U. Baines, one of the Company’s Executive Vice Presidents, received 240,000 shares of the Company’s common stock as merger consideration, which was worth approximately $3.2 million based on the closing price of the Company’s common stock on June 13, 2002. As a result of the Merger, the Company is now an internally managed company, and certain employees of the Manager have become employees of the Company. As a condition to the Merger, the Company entered into direct employment contracts with Lloyd McAdams, Heather U. Baines and Joseph McAdams, adopted an incentive compensation plan for key employees, increased the size of its 1997 Stock Option and Awards Plan and provided for future automatic increases in the size of that plan. Upon the closing of the Merger, the Management Agreement terminated.

The market value of the Company’s common stock issued, valued as of the consummation of the Merger, in excess of the fair value of the net tangible assets acquired, was accounted for as a non-cash charge to operating income in 2002. Since the Company did not acquire tangible net assets from the Manager in the merger, the non-cash charge equaled the value of the consideration paid in the Merger, which was approximately $3.2 million. This non-cash charge did not reduce the Company’s taxable income of which at least 90% must be paid as dividends to stockholders to maintain the Company’s status as a REIT. It did, however, reduce the Company’s reportable net income in the quarter ended June 30, 2002. In addition, the Company incurred $295,000 in merger related expenses.

2002 Incentive Compensation Plan

The Company adopted its 2002 Incentive Compensation Plan which became effective on the effective date of the Merger. Under the 2002 Incentive Compensation Plan, eligible employees of the Company have the opportunity to earn incentive compensation for each fiscal quarter. The total aggregate amount of compensation that may be earned by all employees equals a percentage of taxable net income, before incentive compensation, in excess of the amount that would produce an annualized return on average net worth equal to the Ten-Year US Treasury Rate plus 1% (the “Threshold Return”).

The 2002 Incentive Compensation Plan contains a “high water mark” provision requiring that in any fiscal quarter in which the Company’s taxable net income is an amount less than the amount necessary to earn the

ANWORTH MORTGAGE ASSET CORPORATION

NOTES TO UNAUDITED FINANCIAL STATEMENTS—(Continued)

Threshold Return, the Company will calculate negative incentive compensation for that fiscal quarter which will be carried forward and will offset future incentive compensation earned under the plan, but only with respect to those participants who were participants during the fiscal quarter(s) in which negative incentive compensation was generated.

The percentage of taxable net income in excess of the Threshold Return earned under the plan by all employees is calculated based on the Company’s quarterly average net worth as defined in the Incentive Compensation Plan. The percentage rate used in this calculation is based on a blended average of the following tiered percentage rates:

•

25% for the first $50 million of average net worth;

•

15% for the average net worth between $50 million and $100 million;

•

10% for the average net worth between $100 million and $200 million;

•

5% for the average net worth in excess of $200 million.

The 2002 Incentive Compensation Plan requires that the Company pay all amounts earned thereunder each quarter (subject to offset for accrued negative incentive compensation), and the Company will be required to pay a percentage of such amounts to certain of its executives pursuant to the terms of their employment agreements. For the quarter ended September 30, 2003, eligible employees under the 2002 Incentive Compensation Plan earned $ 0.6 million in incentive compensation.

Employment Agreements

Upon the closing of the Merger, the Company assumed the existing employment agreements of Lloyd McAdams, Heather U. Baines and Joseph McAdams. Such agreements were modified by the addenda entered into between the Company and each of the executives as described below. Pursuant to the terms of the employment agreements, Lloyd McAdams serves as the Company’s President, Chairman and Chief Executive Officer, Joseph McAdams serves as the Company’s Chief Investment Officer and Executive Vice President, and Heather U. Baines serves as the Company’s Executive Vice President . Heather U. Baines receives a $50,000 annual base salary, Lloyd McAdams receives a base salary equal to the greater of (i) $120,000 per annum, or (ii) a per annum amount equal to 0.125% of the Company’s book value, not to exceed $250,000. Joseph McAdams receives a base salary equal to the greater of (i) $100,000 per annum, or (ii) a per annum amount equal to 0.10% of the Company’s book value, not to exceed $250,000.

These employment agreements, as modified by the addenda, also have the following provisions:

•

the three executives are entitled to participate in the 2002 Incentive Compensation Plan and each of these individuals are provided a minimum percentage of the amounts earned under such plan. Lloyd McAdams is entitled to 45% of all amounts paid under the plan; Joe McAdams is entitled to 25% of all amounts paid under the plan, and Heather U. Baines is entitled to 5% of all amounts paid under the plan. The three executives may be paid up to 50% of their respective incentive compensation earned under such plan in the form of the Company’s common stock;

•

the incentive compensation plan may not be amended without the consent of the three executives;

•

in the event of a registered public offering of the Company’s shares, the three executives are entitled to piggyback registration rights in connection with such offering;

•

in the event any of the three executives is terminated without “cause”, or if they terminate for “good reason”, or in the case of Lloyd McAdams or Joseph McAdams, their employment agreements are not

ANWORTH MORTGAGE ASSET CORPORATION

NOTES TO UNAUDITED FINANCIAL STATEMENTS—(Continued)

renewed, then the executives would be entitled to (1) all base salary due under the contracts, (2) all discretionary bonus due under the contracts, (3) a lump sum payment of an amount equal to three years of the executive’s then-current base salary, (4) payment of COBRA medical coverage for eighteen months, (5) immediate vesting of all pension benefits, (6) all incentive compensation to which the executives would have been entitled to under the contract prorated through the termination date, and (7) all expense reimbursements and benefits due and owing the executives through the termination. In addition, under these circumstances, Lloyd McAdams and Joseph McAdams would each be entitled to a lump sum payment equal to 150% of the greater of (i) the highest amount paid or payable to all employees under the 2002 Incentive Compensation Plan during any one of the three fiscal years prior to their termination, and (ii) the highest amount paid, or that would be payable, under the plan during any of the three fiscal years following their termination. Ms. Baines would also be entitled to a lump sum payment equal to all incentive compensation that Ms. Baines would have been entitled to under the plan during the three year period following her termination;

•

the three executives received restricted stock grants of 20,000 shares each, which grants vest in equal, annual installments over ten years following the effective date of the merger; and

•

the three executives are each subject to a one-year non-competition provision following termination of their employment.

The value of the 54,000 unvested shares of restricted stock issued to the above executives, in connection with the 2002 Incentive Compensation Plan, is reflected on the Company’s balance sheet as a reduction to stockholders’ equity. This amount is being amortized to expense over the ten year restricted period until such shares vest and is accounted for as unearned restricted stock.

Agreements with Pacific Income Advisers, Inc.

On June 13, 2002, the Company entered into a sublease with Pacific Income Advisers, Inc. (“PIA”), a company owned by a trust controlled by officers of the Company. Under the sublease, the Company leases 5,500 square feet of office space from PIA and pays at a rate equal to PIA’s obligation, currently $45.36 per square foot. The sublease runs through June 30, 2012 unless earlier terminated pursuant to the master lease. During the third quarter of 2003, the Company paid $62,363 rent to PIA under the sublease which is included in “Other Expenses” on the Statements of Operations. During the nine months ended September 30, 2003, the Company paid $228,481 in rent to PIA under the sublease which is included in “Other Expenses” on the Statements of Operations.

The future minimum lease commitment is as follows:

Year

2003

2004

2005

2006

2007

Thereafter

Total

Commitment

Commitment Amount

65,907

256,960

264,660

272,580

280,775

1,209,890

2,350,772

On October 14, 2002, the Company entered into an administrative agreement with PIA. Under the administrative agreement, PIA provides administrative services and equipment to the Company in the nature of accounting, human resources, operational support and information technology, and the Company pays an annual fee of 7 basis points on the first $225 million of stockholder equity and 3.5 basis points thereafter (paid quarterly in advance) for those services. The administrative agreement is for an initial term of one year and will renew for successive one year terms thereafter unless either party gives notice of termination at least 90 days before the expiration of the then-current annual term. The Company may also terminate the administrative agreement upon 30 days notice for any reason and immediately if there is a material breach by PIA. Included in “Other Expenses” on the Statement of Operations are fees of $51,880 paid to PIA in connection with this agreement during the third quarter and fees of $140,111 for the nine months ended September 30, 2003.

ANWORTH MORTGAGE ASSET CORPORATION

NOTES TO UNAUDITED FINANCIAL STATEMENTS—(Continued)

Belvedere Trust Mortgage Corporation

On November 3, 2003, the Company formed a wholly-owned subsidiary called Belvedere Trust Mortgage Corporation, or Belvedere Trust. Belvedere Trust was formed as a qualified REIT subsidiary to acquire and own mortgage loans, with a focus on the high credit-quality jumbo adjustable rate, hybrid and second-lien mortgage markets. Belvedere Trust was also formed with the intent of securitizing the mortgage loans it acquires and selling mortgage-backed securities in the capital markets. The Company has made an initial investment of $25 million in Belvedere Trust to capitalize its initial mortgage operations.

On November 3, 2003, the Company also formed BT Management Company, L.L.C., or BT Management, a Delaware limited liability company that is owned 50% by the Company, 27.5% by Claus Lund, the Chief Executive Officer of Belvedere Trust, 17.5% by Russell J. Thompson, the Chief Financial Officer of Belvedere Trust, and 5% by Lloyd McAdams, the Company’s Chairman and Chief Executive Officer. BT Management has entered into a management agreement with Belvedere Trust pursuant to which BT Management will manage the day-to-day operations of Belvedere Trust in exchange for an annual base management fee and a quarterly incentive fee. The annual base management fee is equal to 1.15% of the first $300 million of average net invested assets (as defined in the management agreement), plus 0.85% of the portion above $300 million. The incentive fee for each fiscal quarter is equal to an amount equal to 20% of the amount of taxable net income of the Company, before incentive compensation, for such quarter in excess of the amount that would produce an annualized return on equity (calculated by multiplying the return on equity for such fiscal quarter by four) equal to the Ten-Year U.S. Treasury Rate for such fiscal quarter plus 1%.

Certain of the Company’s executive officers serve as officers and directors of Belvedere Trust and officers and managers of BT Management. BT Management has also entered into Employment Agreements with Messrs. Lund and Thompson whereby Mr. Lund serves as the President of BT Management and Mr. Russell serves as Executive Vice President and Treasurer of BT Management. The terms of the employment contracts are for three years and automatically renew for one year terms unless written notice is provided by either party ninety days prior to the end of the current term. Messrs. Lund and Russell will be paid a base salary of $75,000 per year, and can earn incentive compensation pursuant to a compensation program to be adopted by BT Management.

NOTE 5. STOCK OPTION PLAN

The Company has adopted the Anworth Mortgage Asset Corporation 1997 Stock Option and Awards Plan (the “Stock Option Plan”) which authorizes the grant of options to purchase an aggregate of up to 1.8 million of the outstanding shares of the Company’s common stock. The Stock Option Plan authorizes the Board of Directors, or a committee of the Board of Directors, to grant Incentive Stock Options (“ISOs”) as defined under section 422 of the Code, options not so qualified (“NQSOs”), dividend equivalent rights (“DERs”) and stock appreciation rights (“SARs”). The exercise price for any option granted under the Stock Option Plan may not be less than 100% of the fair market value of the shares of common stock at the time the option is granted. As of September 30, 2003, 397,804 shares remained available for future issuance under the Stock Option Plan through any combination of stock options or other awards. The share reserve under the Stock Option Plan automatically increases on the first trading day in January each calendar year by an amount equal to two (2%) percent of the total number of shares of common stock outstanding on the last trading day of December in the prior calendar year, but in no event will this annual increase exceed 300,000 shares and in no event will the total number of shares of common stock in the share reserve (as adjusted for all such annual increases) exceed 3 million shares.

For the quarter ended September 30, 2003, the Company recorded no compensation expense associated with the Stock Option Plan.

ANWORTH MORTGAGE ASSET CORPORATION

NOTES TO UNAUDITED FINANCIAL STATEMENTS—(Continued)

The Company accounts for stock options using the intrinsic value method under the provisions of Accounting Principles Board (“APB”) Opinion No. 25 and provides pro forma net income and pro forma earnings per share disclosures for employee stock option grants as if the fair-value-based method, defined in FAS No. 123, had been applied. Had the Company determined compensation cost based on the fair value at the grant date for its stock options under FAS No. 123, the Company’s net income would have been reduced to the pro forma amounts indicated below for the three months ended September 30:

(in thousands except per share amounts)	2003		2002
Net income, as reported	$	10,367	$	12,101
Deduct: Total stock-based compensation expense determined under the fair value based method for all awards, net of related taxes		5		7

Pro forma net income	$	10,362	$	12,094
Basic income per share, as reported	$	0.29	$	0.52
Pro forma basic income per share	$	0.29	$	0.52
Diluted income per share, as reported	$	0.29	$	0.52
Pro forma diluted income per share	$	0.29	$	0.52

NOTE 6. FAIR VALUES OF FINANCIAL INSTRUMENTS

MBS and other marketable securities are reflected in the financial statements at estimated fair value. Management bases its fair value estimates for MBS and other marketable securities primarily on third-party bid price indications provided by dealers who make markets in these financial instruments when such indications are available. The fair value reported, however, reflects estimates and may not necessarily be indicative of the amounts the Company could realize in a current market exchange. Cash and cash equivalents, interest receivable, reverse repurchase agreements and payables for securities purchased are reflected in the financial statements at their costs, which approximates their fair value because of the short-term nature of these instruments.

NOTE 7. COMMON STOCK

On August 30, 2002, the Company filed a shelf registration statement on Form S-3 with the Securities and Exchange Commission offering up to $350 million of the capital stock of the Company. The registration statement was declared effective on September 10, 2002. As of September 30, 2003, $209.3 million remained available for issuance under the registration statement.

On August 18, 2003, the Company completed a follow-on offering of our common stock. The Company issued 4,025,000 shares of common stock pursuant to a public offering at a price of $14.30 per share and received net proceeds of $54.7 million, net of underwriting discount and other offering expenses of $0.7197 per share.

In December 2002, the Company entered into a sales agreement with Cantor Fitzgerald & Co. (“Cantor”) to sell up to 4.8 million shares of common stock from time to time through a controlled equity offering program under which Cantor acts as sales agent. Sales of the shares have been and will be made by means of ordinary brokers’ transactions on the American Stock Exchange at market prices and through privately negotiated transactions. Commencing February 10, 2003 through the quarter ended September 30, 2003, the Company sold 1.85 million shares under the controlled equity offering program, which provided net proceeds to the Company of approximately $24.6 million. Cantor received an aggregate of approximately $759,000, which represents a commission of 3% on the gross sales price per share of the sales under the sales agreement through September 30, 2003.

ANWORTH MORTGAGE ASSET CORPORATION

NOTES TO UNAUDITED FINANCIAL STATEMENTS—(Continued)

In September 1999, the Company filed with the Securities and Exchange Commission its Dividend Reinvestment and Direct Stock Purchase Plan. The plan allows shareholders and non-shareholders to purchase shares of the Company’s common stock and to reinvest dividends in additional shares of the Company’s common stock. The plan was amended in June 2002 and December 2002 to increase the number of shares available thereunder. During the three month period ended September 30, 2003, the Company issued 1,168,000 shares of common stock under the plan, resulting in proceeds to the Company of approximately $17.6 million.

NOTE 8. SUBSEQUENT EVENTS

On October 15, 2003, the Company declared a dividend of $0.33 per share which is payable on November 10, 2003 to holders of record as of the close of business on October 30, 2003. The ex-dividend date was October 28, 2003.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Cautionary Statement

You should read the following discussion and analysis in conjunction with the financial statements and related notes thereto contained elsewhere in this report. The information contained in this Quarterly Report on Form 10-Q is not a complete description of our business or the risks associated with an investment in our common stock. We urge you to carefully review and consider the various disclosures made by us in this report and in our other reports filed with the Securities and Exchange Commission, or SEC, including our Annual Report on Form 10-K for the year ended December 31, 2002 and our Registration Statement on Form S-3 filed with the SEC on August 30, 2002, as amended, that discuss our business in greater detail.

This Report contains forward-looking statements. Forward-looking statements are those that predict or describe future events or trends and that do not relate solely to historical matters. You can generally identify forward-looking statements as statements containing the words “will,” “believe,” “expect,” “anticipate,” “intend,” “estimate,” “assume” or other similar expressions. You should not rely on our forward-looking statements because the matters they describe are subject to known and unknown risks, uncertainties and other unpredictable factors, many of which are beyond our control. These forward-looking statements are subject to assumptions that are difficult to predict and to various risks and uncertainties. Therefore, our actual results could differ materially and adversely from those expressed in any forward-looking statements as a result of various factors, some of which are listed under the section “Risk Factors.” We undertake no obligation to revise or update publicly any forward-looking statements for any reason.

Critical Accounting Policies

Management has the obligation to ensure that its policies and methodologies are in accordance with generally accepted accounting principles. Management has reviewed and evaluated its critical accounting policies and believes them to be appropriate.

The preparation of financial statements in accordance with generally accepted accounting principles requires management to makes estimates and assumptions in certain circumstances that affect amounts reported in the accompanying financial statements. In preparing these financial statements, management has made its best estimates and judgments of certain amounts included in the financial statements, giving due consideration to materiality. We do not believe that there is a great likelihood that materially different amounts would be reported related to accounting policies described below. Nevertheless, application of these accounting policies involves the exercise of judgment and use of assumptions as to future uncertainties and, as a result, actual results could differ from these estimates.

Our accounting policies are described in Note 1 to our financial statements. Management believes the more significant of these to be as follows:

Revenue Recognition

The most significant source of our revenue is derived from our investments in mortgage-backed securities. We reflect income using the effective yield method, which, through amortization of premiums and accretion of discounts at an effective yield, recognizes periodic income over the estimated life of the investment on a constant yield basis, as adjusted for estimated prepayment activity. Management believes our revenue recognition policies are appropriate to reflect the substance of the underlying transactions.

Valuation of Investment Securities

We carry our investment securities on the balance sheet at fair value. The fair values of our mortgage-backed securities are generally based on market prices provided by certain dealers who make markets in such

securities. The fair values of other marketable securities are obtained from the last reported sale of such securities on its principal exchange or, if no representative sale is reported, the mean between the closing bid and ask prices. If, in the opinion of management, one or more securities prices reported to us are not reliable or unavailable, management estimates the fair value based on characteristics of the security it receives from the issuer and available market information. The fair values reported reflect estimates and may not necessarily be indicative of the amounts we could realize in a current market exchange. Losses on securities classified as available-for-sale which are determined by management to be other than temporary in nature are reclassified from accumulated other comprehensive income to current operations.

Income Taxes

Our financial results do not reflect provisions for current or deferred income taxes. Management believes that we have and intend to continue to operate in a manner that will continue to allow us to be taxed as a REIT and as a result does not expect to pay substantial corporate level taxes. Many of these requirements, however, are highly technical and complex. If we were to fail to meet these requirements, we would be subject to federal income tax.

General

We were formed in October 1997 to invest primarily in mortgage-related assets, including mortgage pass-through certificates, collateralized mortgage obligations, mortgage loans and other securities representing interests in, or obligations backed by, pools of mortgage loans which can be readily financed. We commenced operations on March 17, 1998 upon the closing of our initial public offering. Our principal business objective is to generate net income for distribution to stockholders based upon the spread between the interest income on our mortgage-backed securities and the costs of borrowing to finance our acquisition of mortgage-backed securities.

We are organized for tax purposes as a REIT. Accordingly, we generally distribute substantially all of our earnings to stockholders without paying federal or state income tax at the corporate level on the distributed earnings. As of September 30, 2003, our qualified REIT assets (real estate assets, as defined in the Code, cash and cash items and government securities) were greater than 99% of our total assets, as compared to the Code requirement that at least 75% of our total assets must be qualified REIT assets. As of September 30, 2003, greater than 99% of our 2002 revenue qualified for both the 75% source of income test and the 95% source of income test under the REIT rules. We believe we met all REIT requirements regarding the ownership of our common stock and the distributions of our net income. Therefore, we believe that we continue to qualify as a REIT under the provisions of the Code.

Results Of Operations

Three Months Ended September 30, 2003 Compared to September 30, 2002

For the three months ended September 30, 2003, our net income was $10,367,000, or $0.29 per diluted share, based on an average of 35,618,000 shares outstanding. For the three months ended September 30, 2002, our net income was $12,101,000, or $0.52 per diluted share, based on an average of 23,433,000 shares outstanding.

Net interest income for the three months ended September 30, 2003 totaled $11,127,000, or 48.9% of total interest income, compared to $12,665,000, or 54.7% of total interest income, for the three months ended September 30, 2002. Net interest income is comprised of the interest income earned on mortgage investments, net of premium amortization, less interest expense from borrowings and does not include realized capital gains or losses. As a result of investing the proceeds of our common stock offerings, our assets and borrowings have increased significantly during the past year. This has resulted in a large increase in our income and interest expense compared to last year.

The decrease in net interest income both in absolute terms and as a percentage of total interest income during the three months ended September 30, 2003 compared to the three months ended September 30, 2002

resulted from an increase in premium amortization expense. The increase in premium amortization expense resulted from an increase in the constant prepayment rate (“CPR”) of our MBS, resulting primarily from an extremely high volume of mortgage refinancings driven by the record-low interest rates. These refinancings occurred mainly in the second quarter, and their net effect was realized through the increase in premium amortization expense in the third quarter. Also, during the three months ended September 30, 2003, we realized gains on the sale of assets in the amount of $706,000, or 3.1% of total interest income, compared to gains on sale of $1,838,000, or 7.9% of total interest income, realized during the three months ended September 30, 2002.

For the three months ended September 30, 2003, our operating expenses decreased to $1,466,000, or 6.4% of total interest income, from $2,402,000, or 10.4% of total interest income, for the three months ended September 30, 2002. This decrease was due primarily to an decrease in the incentive compensation paid under the Company’s 2002 Incentive Compensation Plan. The decrease in incentive compensation resulted from a decrease in our return on equity resulting from a decline in net income, which is tied directly to the amount of incentive compensation that the Company pays under the plan.

For the three months ended September 30, 2003, the CPR of our MBS was 46.0%. The CPR of adjustable-rate MBS was 41.0%, the CPR of adjustable-rate hybrid MBS was 49.4% and the CPR of fixed-rate MBS was 27.4%.

For the three months ended September 30, 2002, the CPR of our MBS was 28%. The CPR of adjustable-rate MBS was 34%, the CPR of adjustable-rate hybrid MBS was 31%, and the CPR of fixed-rate MBS was 8%.

Nine Months Ended September 30, 2003 Compared to September 30, 2002

For the nine months ended September 30, 2003, our net income was $35,761,000, or $1.17 per diluted share, based on an average of 30,591,000 shares outstanding. For the nine months ended September 30, 2002, our net income was $19,905,000, or $1.31 per diluted share, based on an average of 15,192,000 shares outstanding.

Net interest income for the nine months ended September 30, 2003 totaled $37,811,000, or 53.7% of total interest income, compared to $24,686,000, or 57.0% of total interest income, for the nine months ended September 30, 2002. As a result of investing the proceeds of our common stock offerings, our assets and borrowings have increased significantly from last year. This has resulted in an increase in our income and interest expense compared to last year. Also, during the nine months ended September 30, 2003, we realized a gain on the sale of assets in the amount of $3,497,000, or 5.0% of total interest income, compared to a gain on sale of $3,493,000, or 8.1% of total interest income, realized during the nine months ended September 30, 2002.

For the nine months ended September 30, 2003, our operating expenses increased to $5,547,000, or 7.9% of total interest income, from $4,799,000, excluding the cost of $3,475,000, incurred in acquiring the internal manager, or 11.1% of total interest income, for the nine months ended September 30, 2002. This increase, in absolute dollars, was due primarily to an increase in the incentive compensation and general administrative expenses. Operating expenses, however, as a percentage of total interest income, decreased.

Financial Condition

At September 30, 2003, we held mortgage assets of approximately $3.7 billion at amortized cost, consisting primarily of $3.25 billion of adjustable-rate mortgage-backed securities, $36 million of floating rate CMOs and $407 million of fixed-rate mortgage-backed securities. This amount represents an approximate 54% increase over the $2.4 billion held at December 31, 2002. At September 30, 2003, we were well within our asset allocation guidelines, since 100% of total assets were mortgage-backed securities guaranteed by an agency of the United States government such as Fannie Mae or Freddie Mac. Of the adjustable-rate mortgage-backed securities owned by us, 32% were adjustable-rate pass-through certificates whose coupons reset within one year. The remaining 68% consisted of 63.1% of 3/1 hybrid adjustable-rate mortgage-backed securities and approximately 4.9% invested in 5/1 hybrid adjustable-rate mortgage-backed securities. Hybrid adjustable-rate mortgage-backed securities have an initial interest rate that is fixed for a certain period, usually three to five years, and thereafter adjust annually for the remainder of the term of the loan.

The following table presents a schedule of mortgage-backed securities at fair value owned at September 30, 2003 and December 31, 2002, classified by type of issuer (dollar amounts in thousands):

	At September 30, 2003				At December 31, 2002
Agency	Fair Value		Portfolio Percentage		Fair Value		Portfolio Percentage
FNMA	$	2,683,347	72.3	%	$	1,631,425	67.1	%
FHLMC		824,458	22.2	%		651,645	26.8	%
GNMA		202,058	5.5	%		147,033	6.1	%

Total Portfolio	$	3,709,863	100	%	$	2,430,103	100	%

The following table classifies our portfolio of mortgage-backed securities owned at September 30, 2003 and December 31, 2002, by type of interest rate index (dollar amounts in thousands):

	At September 30, 2003				At December 31, 2002
Index	Fair Value		Portfolio Percentage		Fair Value		Portfolio Percentage
One-month LIBOR	$	35,472	1.0	%	$	77,055	3.2	%
Six-month LIBOR		14,654	0.4	%		17,614	0.7	%
One-year LIBOR		1,405,801	37.9	%		613,325	25.2	%
Six-month Certificate of Deposit		832	0.0	%		1,239	0.1	%
One-year Constant Maturity Treasury		1,733,539	46.7	%		1,370,783	56.4	%
Cost of Funds Index		114,630	3.1	%		11,313	0.5	%
Fixed-rate		404,935	10.9	%		338,774	13.9	%

Total Portfolio	$	3,709,863	100	%	$	2,430,103	100	%

The fair values indicated do not include interest earned but not yet paid. With respect to our hybrid ARMs, the fair value of these securities appears on the line associated with the index based on which the security will eventually reset, once the initial fixed interest rate period has expired.

Our mortgage-backed securities portfolio had a weighted average coupon of 4.31% as of September 30, 2003. The average coupon of the adjustable-rate securities was 4.16%, the hybrid average coupon was 4.18%, the CMO floaters average coupon was 1.94% and the average coupon of the fixed-rate securities was 5.53%.

At September 30, 2003, the unamortized net premium paid for our mortgage-backed securities was $96.3 million.

We analyze our mortgage-backed securities and the extent to which prepayments impact the yield of the securities. When the rate of prepayments exceeds expectations, we amortize the premiums paid on mortgage assets over a shorter time period, resulting in a reduced yield to maturity on our mortgage assets. Conversely, if actual prepayments are less than the assumed constant prepayment rate, the premium would be amortized over a longer time period, resulting in a higher yield to maturity.

As of September 30, 2003, the average amortized cost of our mortgage-related assets was 102.68%, the average amortized cost of the adjustable-rate securities was 102.66% and the average amortized cost of the fixed-rate securities was 102.81%. As of September 30, 2003, the average interest rate on outstanding repurchase agreements was 1.48% and the average days to maturity was 276 days.

Hedging

We periodically enter into derivative transactions, in the form of forward purchase commitments, which are intended to hedge our exposure to rising rates on funds borrowed to finance our investments in securities. We designate these transactions as cash flow hedges. We also enter into derivative transactions, in the form of forward purchase commitments, which are not designated as hedges.

As part of our asset/liability management policy, we may enter into hedging agreements such as interest rate caps, floors or swaps. These agreements would be entered into to try to reduce interest rate risk and would be designed to provide us with income and capital appreciation in the event of certain changes in interest rates. We review the need for hedging agreements on a regular basis consistent with our capital investment policy. We did not enter into any derivative transactions, nor were any outstanding, during the nine month period ending September 30, 2003.

Liquidity and Capital Resources

Our primary source of funds consists of repurchase agreements, which totaled $3.29 million at September 30, 2003. Our other significant source of funds for the nine months ended September 30, 2003 consisted of payments of principal from our mortgage securities portfolio in the amount of $1.126 million.

As of September 30, 2003, all of our repurchase agreements were fixed-rate term repurchase agreements with original maturities ranging from three to twenty–four months. On September 30, 2003, we had borrowing arrangements with 16 different financial institutions and had borrowed funds under repurchase agreements with 14 of these firms. Because we borrow money based on the fair value of our mortgage-backed securities and because increases in short-term interest rates can negatively impact the valuation of mortgage-backed securities, our borrowing ability could be limited and lenders may initiate margin calls in the event short-term interest rates increase or the value of our mortgage-backed securities declines for other reasons. During the quarter ended September 30, 2003, we had adequate cash flow, liquid assets and unpledged collateral with which to meet our margin requirements during the period.

In the future, we expect that our primary sources of funds will continue to consist of borrowed funds under repurchase agreement transactions with one to twenty–four month maturities and of monthly payments of principal and interest on our mortgage-backed securities portfolio. Our liquid assets generally consist of unpledged mortgage-backed securities, cash and cash equivalents.

From time to time, we raise additional equity depending upon market conditions and other factors. We completed a public offering in February 2002 that raised approximately $40 million in net proceeds. We completed an additional public offering in June 2002 that raised approximately $126 million in net proceeds.

We also intend to raise additional equity through the issuance of capital stock as described in our registration statement on Form S-3 that was initially declared effective by the Securities and Exchange Commission in September 2002. The registration statement was subsequently amended and the post-effective amendment was declared effective in January 2003. We completed a public offering, pursuant to that registration statement in May 2003 and August 2003 that raised approximately $113.6 million in net proceeds.

In December 2002, we entered into a sales agreement with Cantor Fitzgerald & Co. to sell up to 4.8 million shares of common stock from time to time through a controlled equity offering program under which Cantor acts as sales agent. Sales of the shares have been made on the American Stock Exchange and more recently on the New York Stock Exchange by means of ordinary brokers’ transactions at market prices and through privately negotiated transactions. We intend to make such sales when we believe the issuance of stock would be accretive to our shareholders. Through September 30, 2003, we sold 1.85 million shares under the controlled equity offering program, which provided net proceeds to us of approximately $24.55 million. The sales agent received an aggregate of approximately $759,000, which represents a commission of 3% on the gross sales price per share under the sales agreement through September 30, 2003.

For the nine months ended September 30, 2003, we had raised approximately $35.7 million in capital under our dividend reinvestment and direct stock purchase plan.

Stockholders’ Equity

We use available-for-sale treatment for our mortgage-backed securities. These assets are carried on the balance sheet at fair value rather than historical amortized cost. Based upon such available-for-sale treatment, our equity base at September 30, 2003 was $422.4 million, or $11.04 per share. The impact, however, of the $0.33 per share dividend declared on October 15, 2003 will reduce book value to approximately $10.70 per share.

With our available-for-sale accounting treatment, unrealized fluctuations in fair values of assets do not impact GAAP income or taxable income but rather are reflected on the balance sheet by changing the carrying value of the assets and reflecting the change in stockholders’ equity under “Accumulated other comprehensive income (loss), unrealized gain (loss) on available-for-sale securities.” Accumulated other comprehensive loss, unrealized loss on available-for-sale securities was $10.5 million, or 0.28% less than the amortized cost of mortgage-backed securities at September 30, 2003. This was in contrast to other comprehensive income consisting of unrealized gains of $14.9 million at December 31, 2002. This change was due to an increase in interest rates, which inversely affects the fair value of our MBS.

As a result of this mark-to-market accounting treatment, our book value and book value per share are likely to fluctuate far more than if we used historical amortized cost accounting. As a result, comparisons with companies that use historical cost accounting for some or all of their balance sheet may not be meaningful.

Unrealized changes in the fair value of mortgage-backed securities have one significant and direct effect on our potential earnings and dividends. Specifically, positive mark-to-market changes will increase our equity base and allow us to increase our borrowing capacity while negative changes will tend to limit borrowing capacity under our capital investment policy. A very large negative change in the fair value of our mortgage-backed securities might reduce our liquidity, requiring us to sell assets with the likely result of realized losses upon sale.

Subsequent Events

RISK FACTORS

An investment in our stock involves a number of risks. Before making a decision to purchase our securities, you should carefully consider all of the risks described in this quarterly report. If any of the risks discussed in this quarterly report actually occur, our business, financial condition and results of operations could be materially adversely affected. If this were to occur, the trading price of our securities could decline significantly and you may lose all or part of your investment.

Risk Related to Our Business

Interest rate mismatches between our adjustable-rate mortgage-backed securities and our borrowings used to fund our purchases of the assets may reduce our income during periods of changing interest rates.

We fund most of our acquisitions of adjustable-rate mortgage-backed securities with borrowings that have interest rates based on indices and repricing terms similar to, but of shorter maturities than, the interest rate indices and repricing terms of our mortgage-backed securities. Accordingly, if short-term interest rates increase, this may adversely affect our profitability.

Most of the mortgage-backed securities we acquire are adjustable-rate securities. This means that their interest rates may vary over time based upon changes in a short-term interest rate index. Therefore, in most cases the interest rate indices and repricing terms of the mortgage-backed securities that we acquire and their funding sources will not be identical, thereby creating an interest rate mismatch between assets and liabilities. While the historical spread between relevant short-term interest rate indices has been relatively stable, there have been periods when the spread between these indices was volatile. During periods of changing interest rates, these mismatches could reduce our net income, dividend yield and the market price of our stock.

The interest rates on our borrowings generally adjust more frequently than the interest rates on our adjustable-rate mortgage-backed securities. For example, on September 30, 2003, our adjustable-rate mortgage-backed securities had a weighted average term to next rate adjustment of approximately 21 months, while our borrowings had a weighted average term to next rate adjustment of 276 days. Accordingly, in a period of rising interest rates, we could experience a decrease in net income or a net loss because the interest rates on our borrowings adjust faster than the interest rates on our adjustable-rate mortgage-backed securities.

We may experience reduced net interest income from holding fixed-rate investments during periods of rising interest rates.

We generally fund our acquisition of fixed-rate mortgage-backed securities with short-term borrowings. During periods of rising interest rates, our costs associated with borrowings used to fund acquisition of fixed-rate assets are subject to increases while the income we earn from these assets remains substantially fixed. This reduces or could eliminate the net interest spread between the fixed-rate mortgage-backed securities that we purchase and our borrowings used to purchase them, which could lower our net interest income or cause us to suffer a loss. On September 30, 2003, 10.9% of our mortgage-backed securities were fixed-rate securities.

Increased levels of prepayments from mortgage-backed securities may decrease our net interest income.

Pools of mortgage loans underlie the mortgage-backed securities that we acquire. We generally receive payments from principal payments that are made on these underlying mortgage loans. When borrowers prepay their mortgage loans faster than expected, this results in prepayments that are faster than expected on the mortgage-backed securities. Faster than expected prepayments could adversely affect our profitability, including in the following ways:

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We usually purchase mortgage-backed securities that have a higher interest rate than the market interest rate at the time. In exchange for this higher interest rate, we pay a premium over the par value to acquire the security. In accordance with accounting rules, we amortize this premium over the term of the

mortgage-backed security. If the mortgage-backed security is prepaid in whole or in part prior to its maturity date, however, we expense the premium that was prepaid at the time of the prepayment. On September 30, 2003, approximately 99.9% of our mortgage-backed securities were acquired at a premium.

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We anticipate that a substantial portion of our adjustable-rate mortgage-backed securities may bear interest rates that are lower than their fully indexed rates, which are equivalent to the applicable index rate plus a margin. If an adjustable-rate mortgage-backed security is prepaid prior to or soon after the time of adjustment to a fully-indexed rate, we will have held that mortgage-backed security while it was less profitable and lost the opportunity to receive interest at the fully indexed rate over the remainder of its expected life.

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If we are unable to acquire new mortgage-backed securities similar to the prepaid mortgage-backed securities, our financial condition, results of operation and cash flow would suffer.

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

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

We may incur increased borrowing costs related to repurchase agreements and that would adversely affect our profitability.

Currently, all of our borrowings are collateralized borrowings in the form of repurchase agreements. If the interest rates on these repurchase agreements increase, that would adversely affect our profitability.

Our borrowing costs under repurchase agreements generally correspond to short-term interest rates such as LIBOR or a short-term Treasury index, plus or minus a margin. The margins on these borrowings over or under short-term interest rates may vary depending upon:

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the movement of interest rates;

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the availability of financing in the market; and

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the value and liquidity of our mortgage-backed securities.

Interest rate caps on our adjustable-rate mortgage-backed securities may reduce our income or cause us to suffer a loss during periods of rising interest rates.

Our adjustable-rate mortgage-backed securities are typically subject to periodic and lifetime interest rate caps. Periodic interest rate caps limit the amount an interest rate can increase during any given period. Lifetime interest rate caps limit the amount an interest rate can increase through maturity of a mortgage-backed security. Our borrowings are not subject to similar restrictions. Accordingly, in a period of rapidly increasing interest rates, the interest rates paid on our borrowings could increase without limitation while caps would limit the interest rates on our adjustable-rate mortgage-backed securities. This problem is magnified for our adjustable-rate mortgage-backed securities that are not fully indexed. Further, some adjustable-rate mortgage-backed securities may be subject to periodic payment caps that result in a portion of the interest being deferred and added to the principal outstanding. As a result, we could receive less cash income on adjustable-rate mortgage-backed securities than we need to pay interest on our related borrowings. These factors could lower our net interest income or cause us to suffer a loss during periods of rising interest rates. On September 30, 2003, approximately 89% of our mortgage-backed securities were adjustable-rate securities.

Our leveraging strategy increases the risks of our operations.

We generally borrow between eight and twelve times the amount of our equity, although our borrowings may at times be above or below this amount. We incur this leverage by borrowing against a substantial portion of the market value of our mortgage-backed securities. Use of leverage can enhance our investment returns. Leverage, however, also increases risks. In the following ways, the use of leverage increases our risk of loss and may reduce our net income by increasing the risks associated with other risk factors, including a decline in the market value of our mortgage-backed securities or a default of a mortgage-related asset:

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The use of leverage increases our risk of loss resulting from various factors including rising interest rates, increased interest rate volatility, downturns in the economy and reductions in the availability of financing or deteriorations in the conditions of any of our mortgage-related assets.

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A majority of our borrowings are secured by our mortgage-backed securities, generally under repurchase agreements. A decline in the market value of the mortgage-backed securities used to secure these debt obligations could limit our ability to borrow or result in lenders requiring us to pledge additional collateral to secure our borrowings. In that situation, we could be required to sell mortgage-backed securities under adverse market conditions in order to obtain the additional collateral required by the lender. If these sales are made at prices lower than the carrying value of the mortgage-backed securities, we would experience losses.

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A default of a mortgage-related asset that constitutes collateral for a loan could also result in an involuntary liquidation of the mortgage-related asset. This would result in a loss to us of the difference between the value of the mortgage-related asset upon liquidation and the amount borrowed against the mortgage-related asset.

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To the extent we are compelled to liquidate qualified REIT assets to repay debts, our compliance with the REIT rules regarding our assets and our sources of income could be negatively affected, which would jeopardize our status as a REIT. Losing our REIT status would cause us to lose tax advantages applicable to REITs and may decrease our overall profitability and distributions to our stockholders.

We have not extensively used derivatives to mitigate our interest rate and prepayment risks and this leaves us exposed to certain risks.

Our policies permit us to enter into interest rate swaps, caps and floors and other derivative transactions to help us reduce our interest rate and prepayment risks described above. We have made only limited use of these types of instruments as discussed under “Hedging” above. We have determined that, generally, the costs of these transactions outweigh their benefits. This strategy saves us the additional costs of such hedging transactions, but it leaves us exposed to the types of risks that such hedging transactions would be designed to reduce. If we decide to enter into derivative transactions in the future, these transactions may mitigate our interest rate and prepayment risks but cannot eliminate these risks. Additionally, the use of derivative transactions could have a negative impact on our earnings.

An increase in interest rates may adversely affect our book value.

Increases in interest rates may negatively affect the market value of our mortgage-related assets. Our fixed-rate securities are generally more negatively affected by these increases. In accordance with accounting rules, we reduce our book value by the amount of any decrease in the market value of our mortgage-related assets. Losses on securities classified as available-for sale which are determined by management to be other than temporary in nature are reclassified from accumulated other comprehensive income to current operations.

We may invest in leveraged mortgage derivative securities that generally experience greater volatility in market prices, thus exposing us to greater risk with respect to their rate of return.

We may acquire leveraged mortgage derivative securities that may expose us to a high level of interest rate risk. The characteristics of leveraged mortgage derivative securities result in greater volatility in their market

prices. Thus, acquisition of leveraged mortgage derivative securities would expose us to the risk of greater price volatility in our portfolio and that could adversely affect our net income and overall profitability.

We depend on borrowings to purchase mortgage-related assets and reach our desired amount of leverage. If we fail to obtain or renew sufficient funding on favorable terms, we will be limited in our ability to acquire mortgage-related assets and our earnings and profitability would decline.

We depend on short-term borrowings to fund acquisitions of mortgage-related assets and reach our desired amount of leverage. Accordingly, our ability to achieve our investment and leverage objectives depends on our ability to borrow money in sufficient amounts and on favorable terms. In addition, we must be able to renew or replace our maturing short-term borrowings on a continuous basis. Moreover, we depend on a few lenders to provide the primary credit facilities for our purchases of mortgage-related assets.

If we cannot renew or replace maturing borrowings, we may have to sell our mortgage-related assets under adverse market conditions and may incur permanent capital losses as a result. Any number of these factors in combination may cause difficulties for us, including a possible liquidation of a major portion of our portfolio at disadvantageous prices with consequent losses, which may render us insolvent.

Possible market developments could cause our lenders to require us to pledge additional assets as collateral. If our assets are insufficient to meet the collateral requirements, then we may be compelled to liquidate particular assets at an inopportune time.

Possible market developments, including a sharp rise in interest rates, a change in prepayment rates or increasing market concern about the value or liquidity of one or more types of mortgage-related assets in which our portfolio is concentrated, may reduce the market value of our portfolio, which may cause our lenders to require additional collateral. This requirement for additional collateral may compel us to liquidate our assets at a disadvantageous time, thus adversely affecting our operating results and net profitability.

Our use of repurchase agreements to borrow funds may give our lenders greater rights in the event that either we or a lender files for bankruptcy.

Our borrowings under repurchase agreements may qualify for special treatment under the bankruptcy code, giving our lenders the ability to avoid the automatic stay provisions of the bankruptcy code and to take possession of and liquidate our collateral under the repurchase agreements without delay in the event that we file for bankruptcy. Furthermore, the special treatment of repurchase agreements under the bankruptcy code may make it difficult for us to recover our pledged assets in the event that a lender files for bankruptcy. Thus, the use of repurchase agreements exposes our pledged assets to risk in the event of a bankruptcy filing by either a lender or us.

Because assets we acquire may experience periods of illiquidity, we may lose profits or be prevented from earning capital gains if we cannot sell mortgage-related assets at an opportune time.

We bear the risk of being unable to dispose of our mortgage-related assets at advantageous times or in a timely manner because mortgage-related assets generally experience periods of illiquidity. The lack of liquidity may result from the absence of a willing buyer or an established market for these assets, as well as legal or contractual restrictions on resale. As a result, the illiquidity of mortgage-related assets may cause us to lose profits or the ability to earn capital gains.

We depend on our key personnel and the loss of any of our key personnel could severely and detrimentally affect our operations.

We depend on the diligence, experience and skill of our officers and other employees for the selection, structuring and monitoring of our mortgage-related assets and associated borrowings. Our key officers include

Lloyd McAdams, President, Chairman and Chief Executive Officer, Joseph McAdams, Chief Investment Officer, Executive Vice President and Director, Thad Brown, Chief Financial Officer, Evangelos Karagiannis, Vice President, and Bistra Pashamova, Vice President. Our dependence on our key personnel is heightened by the fact that we have a relatively small number of employees, and the loss of any key person could harm our entire business, financial condition, cash flow and results of operations. In particular, the loss of the services of Lloyd McAdams or Joseph McAdams could seriously harm our business.

Our officers devote a portion of their time to another company in capacities that could create conflicts of interest that may adversely affect our investment opportunities; this lack of a full-time commitment could also adversely affect our operating results.

Lloyd McAdams, Joseph McAdams, Evangelos Karagiannis, Bistra Pashamova and others are involved in investing both our assets and approximately $4 billion in mortgage-backed securities and other fixed income assets for institutional clients and individual investors through Pacific Income Advisers, Inc., or PIA. A trust controlled by Lloyd McAdams and Heather U. Baines is the principal stockholder of PIA. These multiple responsibilities may create conflicts of interest if these officers are presented with opportunities that may benefit both us and the clients of PIA. These officers allocate investments among our portfolio and the clients of PIA by determining the entity or account for which the investment is most suitable. In making this determination, these officers consider the investment strategy and guidelines of each entity or account with respect to acquisition of assets, leverage, liquidity and other factors that our officers determine appropriate. These officers, however, have no obligation to make any specific investment opportunities available to us and the above mentioned conflicts of interest may result in decisions or allocations of securities that are not in our best interests.

Each of our officers is also an officer and employee of PIA and devotes a portion of their time to PIA. In addition, several of our officers are officers and managers of BT Management Company, L.L.C., the company that will manage the day-to-day operations of Belvedere Trust Mortgage Corporation, our newly formed mortgage loan subsidiary, and Lloyd McAdams, our Chairman and Chief Executive Officer, is also an owner and officer of Syndicated Capital, a registered broker-dealer. Our officers service to PIA, BT Management Company, L.L.C. and Syndicated Capital allow them to spend only part of their time and effort managing our company as they are required to devote a portion of their time and effort to the management of other companies and this may adversely affect our overall management and operating results.

Our board of directors may change our operating policies and strategies without prior notice or stockholder approval and such changes could harm our business, results of operation and stock price.

Our board of directors can modify or waive our current operating policies and our strategies without prior notice and without stockholder approval. We cannot predict the effect any changes to our current operating policies and strategies may have on our business, operating results and stock price, however, the effects may be adverse.

Our incentive compensation plan may create an incentive to increase the risk of our mortgage portfolio in an attempt to increase compensation.

In addition to their base salaries, management and key employees are eligible to earn incentive compensation for each fiscal year pursuant to our incentive compensation plan. Under the plan, the aggregate amount of compensation that may be earned by all employees equals a percentage of taxable net income, before incentive compensation, in excess of the amount that would produce an annualized return on average net worth equal to the ten-year US Treasury Rate plus 1%. In any fiscal quarter in which our taxable net income is an amount less than the amount necessary to earn this threshold return, we calculate negative incentive compensation for that fiscal quarter which will be carried forward and will offset future incentive compensation earned under the plan, but only with respect to those participants who were participants during the fiscal

quarter(s) in which negative incentive compensation was generated. Although negative incentive compensation is used to offset future incentive compensation, as our management evaluates different mortgage-backed securities for our investment, there is a risk that management will cause us to assume more risk than is prudent.

Competition may prevent us from acquiring mortgage-related assets at favorable yields and that would negatively impact our profitability.

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

Our investment policy involves risks associated with the credit quality of our investments. If the credit quality of our investments declines or if there are defaults on the investments we make, our profitability may decline and we may suffer losses.

Our mortgage-backed securities have primarily been agency certificates that, although not rated, carry an implied “AAA” rating. Agency certificates are mortgage-backed securities where either Freddie Mac or Fannie Mae guarantees payments of principal or interest on the certificates. Freddie Mac and Fannie Mae are government-sponsored enterprises and securities guaranteed by these entities are not guaranteed by the United States government. Our capital investment policy, however, provides us with the ability to acquire a material amount of lower credit quality mortgage-backed securities. If we acquire mortgage-backed securities of lower credit quality, our profitability may decline and we may incur losses if there are defaults on the mortgages backing those securities or if the rating agencies downgrade the credit quality of those securities or the securities of Fannie Mae and Freddie Mac.

We have not previously engaged in the business of acquiring and securitizing whole mortgage loans and we may not be successful.

We recently formed a new subsidiary called Belvedere Trust Mortgage Corporation, or Belvedere Trust, to engage in the business of acquiring and securitizing whole mortgage loans. Although we hired a management team that we believe has appropriate experience managing the acquisition and securitization of whole loans, we have never engaged in this particular business and we may not be successful. The acquisition of whole loans and the securitization process are inherently complex and involve risks related to the types of mortgages we seek to acquire, interest rate changes, funding sources, delinquency rates, borrower bankruptcies and other factors that we may not be able to manage. Our failure to manage these and other risks could have a material adverse affect on our business and results of operations.

Belvedere Trust’s investment strategy of acquiring, accumulating and securitizing loans involves credit risk.

While Belvedere Trust intends to securitize the loans that it acquires into high quality assets in order to achieve better financing rates and to improve its access to financing, it bears the risk of loss on any loans that its acquires or originates and which it subsequently securitizes. Belvedere Trust will acquire loans that are not credit enhanced and that do not have the backing of Fannie Mae or Freddie Mac. Accordingly, it will be subject to risks of borrower default, bankruptcy and special hazard losses (such as those occurring from earthquakes) with respect to those loans to the extent that there is any deficiency between the value of the mortgage collateral and insurance and the principal amount of the loan. In the event of a default on any such loans that it holds, Belvedere Trust would bear the loss of principal between the value of the mortgaged property and the outstanding indebtedness, as well as the loss of interest.

Belvedere Trust will require a significant amount of cash, and if it is not available, the business and financial performance of Belvedere Trust will be significantly harmed.

Belvedere Trust will require substantial cash to fund its loan acquisitions, to pay its loan acquisition expenses and to hold its loans pending sale or securitization. Belvedere Trust will also need cash to meet its working capital and other needs. Pending sale or securitization of a pool of mortgage loans, Belvedere Trust will acquire mortgage loans that it expects to finance through borrowings from warehouse lines of credit and repurchase facilities. It is possible that Belvedere Trust’s future warehouse lenders could experience changes in their ability to advance funds to Belvedere Trust, independent of the performance of Belvedere Trust or its loans. We anticipate that Belvedere Trust’s repurchase facilities will be dependent on the ability of counter-parties to re-sell Belvedere Trust’s obligations to third parties. If there is a disruption of the repurchase market generally, or if one of Belvedere Trust’s counter-parties is itself unable to access the repurchase market, Belvedere Trust’s access to this source of liquidity could be adversely affected. Cash could also be required to meet margin calls under the terms of Belvedere Trust’s borrowings in the event that there is a decline in the market value of the loans that collateralize its debt, the terms of short-term debt become less attractive, or for other reasons. Any of these events would have a material adverse affect on Belvedere Trust.

For some period of time, Belvedere Trust will use the net proceeds of our investment in Belvedere Trust to meet its operating expenses as it acquires new loans for its portfolio. If Belvedere Trust has fully invested all of the net proceeds of our investment in it prior to the point at which Belvedere Trust generates sufficient cash for it to fund its operations, if it ever does, then Belvedere Trust will need to either restructure the securities supporting its portfolio, require additional capital from us or third parties or, if it is unable to sell additional securities on reasonable terms or at all, it will need to either reduce its acquisition business or sell a higher portion of its loans. In the event that Belvedere Trust’s liquidity needs exceed its access to liquidity, it may need to sell assets at an inopportune time, thus reducing its earnings. Adverse cash flow could threaten Belvedere Trust’s ability to satisfy the income and asset tests necessary to maintain its status as a REIT or its solvency.

The use of securitizations with over-collateralization requirements may have a negative impact on Belvedere Trust’s cash flow.

Belvedere Trust expects that its securitizations will restrict its cash flow if the loan delinquencies exceed certain levels. The terms of the securitization will generally provide that, if certain delinquencies and/or losses exceed the specified levels based on rating agencies’ (or the financial guaranty insurer’s, if applicable) analysis of the characteristics of the loans pledged to collateralize the securities, the required level of over-collateralization may be increased or may be prevented from decreasing as would otherwise be permitted if losses and/or delinquencies did not exceed those levels. Other tests (based on delinquency levels or other criteria) may restrict Belvedere Trust’s ability to receive net interest income from a securitization transaction. We cannot assure you that the performance tests will be satisfied. Nor can we assure you, in advance of completing negotiations with the rating agencies or other key transaction parties on our future securitizations, the actual terms of the delinquency tests, over-collateralization terms, cash flow release mechanisms or other significant factors regarding the calculation of net excess income to Belvedere Trust. Failure to obtain the terms on a favorable basis may materially and adversely affect the availability of net excess income to Belvedere Trust.

The success of Belvedere Trust’s loan business will depend upon its ability to ensure that loans to be held in its securitizations are serviced effectively.

The success of Belvedere Trust’s mortgage loan business will depend to a great degree upon its ability to ensure that its loans held for securitization are serviced effectively. In general, it is the intention of Belvedere Trust to acquire loans “servicing retained”, where the loans will be serviced by the originating or selling institution. Belvedere Trust has no experience servicing a portfolio of loans. If Belvedere Trust is required to purchase the servicing of a loan portfolio in order to acquire a portfolio with desirable attributes, Belvedere Trust will be required to implement a servicing function or contract with a third party to service the loans in order for

Belvedere Trust to implement its strategy. We cannot assure you that Belvedere Trust will be able to service the loans or effectively supervise a sub-servicing relationship according to industry standards. Failure to service the loans properly will harm Belvedere Trust’s business and operating results. Prior to either building the servicing capabilities that Belvedere Trust may require or acquiring an existing servicing operation that has such capabilities, if ever, Belvedere Trust anticipates contracting with an experienced servicer of non-conforming loans to “sub-service” its loans. The fees paid to a subservicer will reduce to a certain extent the revenue Belvedere Trust is able to retain from its loans, and its net interest income will be reduced by and at risk, depending on the effectiveness of the servicing company.

If actual prepayments or defaults with respect to mortgages serviced occurs more quickly than originally assumed, the value of Belvedere Trust’s mortgage servicing rights would be subject to downward adjustment.

When Belvedere Trust purchases mortgages that include the associated servicing rights, the allocated cost of the servicing rights will be reflected on its financial statements as mortgage servicing rights. To determine the fair value of these servicing rights, Belvedere Trust will use assumptions to estimate future net servicing income including projected discount rates, mortgage loan prepayments and credit losses. If actual prepayments or defaults with respect to loans serviced occur more quickly than Belvedere Trust originally assumed, Belvedere Trust would have to reduce the carrying value of its mortgage servicing rights. Belvedere Trust does not know if its assumptions will prove correct.

Belvedere Trust will be externally managed and this may diminish or eliminate our return on our investment in this line of business.

Belvedere Trust will be externally managed pursuant to a management agreement between Belvedere Trust and BT Management Company, L.L.C., or BT Management. Although we own 50% of BT Management, it is also owned 27.5% by Claus Lund, the Chief Executive Officer of Belvedere Trust, 17.5% by Russell J. Thompson, the Chief Financial Officer of Belvedere Trust and 5% by Lloyd McAdams, our Chairman and Chief Executive Officer. Our ability to generate profits from our ownership of Belvedere Trust, if any, could be greatly diminished due to the fact that we will be required to pay a base management fee to BT Management and we may also be required to pay an incentive fee. An externally managed structure may not optimize our interest in Belvedere Trust and, if we are unable to properly manage fixed costs at Belvedere Trust could, when combined with the base management fee, result in losses at Belvedere Trust.

Our Chairman has an ownership interest in BT Management that creates potential conflicts of interest.

Mr. McAdams, our Chairman and Chief Executive Officer, has a direct ownership interest in BT Management that creates potential conflicts of interest. Mr. McAdams is Chairman of the Board and Chief Executive Officer and a member of the Board of Managers of BT Management and owns an equity interest in BT Management. Under the management agreement between Belvedere Trust and BT Management, BT Management is entitled to earn certain incentive compensation based on the level of Belvedere Trust’s annualized net income. In evaluating mortgage assets for investment and with respect to other management strategies, an undue emphasis on the maximization of income at the expense of other criteria could result in increased risk to the value of our portfolio.

Risks Related to REIT Compliance and Other Matters

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

We believe that since our initial public offering in 1998 we have operated so as to qualify as a REIT under the Internal Revenue Code of 1986, as amended (the Code), and we intend to continue to meet the requirements for taxation as a REIT. Nevertheless, we may not remain qualified as a REIT in the future. Qualification as a

REIT involves the application of highly technical and complex Code provisions for which only a limited number of judicial or administrative interpretations exist. Even a technical or inadvertent mistake could jeopardize our REIT status. For example, if Belvedere Trust fails to qualify as a REIT, we could lose our REIT status under certain circumstances. Furthermore, Congress or the IRS might change tax laws or regulations and the courts might issue new rulings, in each case potentially having retroactive effect that could make it more difficult or impossible for us to qualify as a REIT. If we fail to qualify as a REIT in any tax year, then:

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we would be taxed as a regular domestic corporation, which, among other things, means being unable to deduct distributions to stockholders in computing taxable income and being subject to federal income tax on our taxable income at regular corporate rates;

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any resulting tax liability could be substantial and would reduce the amount of cash available for distribution to stockholders; and

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unless we were entitled to relief under applicable statutory provisions, we would be disqualified from treatment as a REIT for the subsequent four taxable years following the year during which we lost our qualification, and thus, our cash available for distribution to stockholders would be reduced for each of the years during which we do not qualify as a REIT.

Complying with REIT requirements may cause us to forego otherwise attractive opportunities.

In order to qualify as a REIT for federal income tax purposes, we must continually satisfy tests concerning, among other things, our sources of income, the nature and diversification of our mortgage-backed securities and other assets, including our stock in Belvedere Trust, the amounts we distribute to our stockholders and the ownership of our stock. We may also be required to make distributions to stockholders at disadvantageous times or when we do not have funds readily available for distribution. Thus, compliance with REIT requirements may hinder our ability to operate solely on the basis of maximizing profits.

Complying with REIT requirements may limit our ability to hedge effectively.

The REIT provisions of the Code may substantially limit our ability to hedge mortgage-backed securities and related borrowings by requiring us to limit our income in each year from qualified hedges, together with any other income not generated from qualified REIT real estate assets, to less than 25% of our gross income. In addition, we must limit our aggregate income from hedging and services from all sources, other than from qualified REIT real estate assets or qualified hedges, to less than 5% of our annual gross income. As a result, although we do not currently engage in hedging transactions, we may in the future have to limit our use of advantageous hedging techniques. This could result in greater risks associated with changes in interest rates than we would otherwise want to incur. If we were to violate the 25% or 5% limitations, we may have to pay a penalty tax equal to the amount of income in excess of those limitations, multiplied by a fraction intended to reflect our profitability. If we fail to satisfy the 25% and 5% limitations, unless our failure was due to reasonable cause and not due to willful neglect, we could lose our REIT status for federal income tax purposes.

Complying with REIT requirements may force us to liquidate otherwise attractive investments.

In order to qualify as a REIT, we must also ensure that at the end of each calendar quarter at least 75% of the value of our assets consists of cash, cash items, government securities and qualified REIT real estate assets. The remainder of our investment in securities generally cannot include more than 10% of the outstanding voting securities of any one issuer or more than 10% of the total value of the outstanding securities of any one issuer. In addition, in general, no more than 5% of the value of our assets can consist of the securities of any one issuer. The 5% and 10% limitations described above will apply to our investment in Belvedere Trust unless Belvedere Trust is a qualified REIT subsidiary of ours (i.e., we own 100% of Belvedere Trust’s outstanding stock), Belvedere Trust is a qualified REIT, or Belvedere Trust is a taxable REIT subsidiary of ours. If we fail to comply with these requirements, we must dispose of a portion of our assets within 30 days after the end of the calendar quarter in order to avoid losing our REIT status and suffering adverse tax consequences.

Complying with REIT requirements may force us to borrow to make distributions to stockholders.

As a REIT, we must distribute 90% of our annual taxable income (subject to certain adjustments) to our stockholders. From time to time, we may generate taxable income greater than our net income for financial

reporting purposes from, among other things, amortization of capitalized purchase premiums, or our taxable income may be greater than our cash flow available for distribution to stockholders. For example, our taxable income would exceed our net income for financial reporting purposes to the extent that compensation paid to our chief executive officer and our other four highest paid officers exceeds $1,000,000 for any such officer for any calendar year under Section 162(m) of the tax code. Since payments under our 2002 Incentive Compensation Plan do not qualify as performance-based compensation under Section 162(m), a portion of the payments made under such plan to certain of such officers would not be deductible for federal income tax purposes under such circumstances. If we do not have other funds available in these situations, we may be unable to distribute substantially all of our taxable income as required by the REIT provisions of the tax code. Thus, we could be required to borrow funds, sell a portion of our mortgage-backed securities at disadvantageous prices or find another alternative source of funds. These alternatives could increase our costs or reduce our equity.

If Belvedere Trust fails to qualify as a REIT, a qualified REIT subsidiary or a taxable REIT subsidiary, we may lose our REIT status.

As long as we own 100% of Belvedere Trust’s outstanding stock, Belvedere Trust will be treated as a qualified REIT subsidiary for federal income tax purposes. As such, for federal income tax purposes, we will not be treated as owning stock in Belvedere Trust and Belvedere Trust’s assets, liabilities and income will generally be treated as our assets, liabilities and income for purposes of the REIT qualification tests described below under “Material Federal Income Tax Considerations.” If, however, we do not own 100% of Belvedere Trust’s outstanding stock, and Belvedere Trust does not qualify as a REIT or a taxable REIT subsidiary, we will lose our REIT status if, at the end of any calendar quarter, the value of our Belvedere Trust securities exceeds 5% of the value of our total assets or we own more than 10% of the value or voting power of Belvedere Trust’s outstanding securities. If we fail to satisfy the 5% test or the 10% test at the end of any calendar quarter, a 30-day “cure” period may apply following the close of the quarter. If we make an election to treat Belvedere Trust as a taxable REIT subsidiary, the total value of any securities we own in Belvedere Trust and all of our other taxable REIT subsidiaries, if any, may not exceed 20% of the value of our total assets at the end of any calendar quarter. Since Belvedere Trust intends that it will elect to be taxed as a REIT, however, we do not intend to make a taxable REIT subsidiary election for Belvedere Trust.

If Belvedere Trust fails to qualify as a REIT, Belvedere Trust will be subject to corporate income taxes on its taxable income, which will reduce the amount available for distribution to us.

Belvedere Trust was formed as a qualified REIT subsidiary and intends that it will meet the requirements for taxation as a REIT in 2004 and make an election to be taxed as a REIT beginning with its taxable year ending December 31, 2004.Although Belvedere Trust expects to operate in a manner to permit it to qualify as a REIT in 2004 and continue to maintain such qualification, the actual results of Belvedere Trust’s operations for any particular taxable year may not satisfy these requirements. If Belvedere Trust fails to qualify for taxation as a REIT in any taxable year, and the relief provisions of the Code do not apply, Belvedere Trust will be required to pay tax on Belvedere Trust’s taxable income in that taxable year and all subsequent taxable years at regular corporate rates. Distributions to us in any year in which Belvedere Trust fails to qualify as a REIT will not be deductible by Belvedere Trust. As a result, we anticipate that Belvedere Trust’s failure to qualify as a REIT would reduce the cash available for distribution to us. Unless entitled to relief under specific statutory provisions, if Belvedere Trust fails to maintain its REIT status, Belvedere Trust will also be disqualified from taxation as a REIT for the four taxable years following the year in which it loses its qualification.

Failure to maintain an exemption from the Investment Company Act would adversely affect our results of operations.

We believe that we conduct our business in a manner that allows us to avoid being regulated as an investment company under the Investment Company Act of 1940, as amended. If we fail to continue to qualify for an exemption from registration as an investment company, our ability to use leverage would be substantially

reduced and we would be unable to conduct our business as planned. The Investment Company Act exempts entities that are primarily engaged in the business of purchasing or otherwise acquiring “mortgages and other liens on and interests in real estate.” Under the SEC’s current interpretation, qualification for this exemption generally requires us to maintain at least 55% of our assets directly in qualifying real estate interests. Mortgage-backed securities that do not represent all the certificates issued with respect to an underlying pool of mortgages may be treated as securities separate from the underlying mortgage loans and thus may not qualify for purposes of the 55% requirement. Therefore, our ownership of these mortgage-backed securities is limited by the Investment Company Act. In meeting the 55% requirement under the Investment Company Act, we treat as qualifying interests mortgage-backed securities issued with respect to an underlying pool for which we hold all issued certificates. If the SEC or its staff adopts a contrary interpretation, we could be required to sell a substantial amount of our mortgage-backed securities under potentially adverse market conditions. Further, in order to maintain our exemption from registration as an investment company, we may be precluded from acquiring mortgage-backed securities whose yield is somewhat higher than the yield on mortgage-backed securities that could be purchased in a manner consistent with the exemption.

Additional Risk Factors

We may not be able to use the money we raise to acquire investments at favorable prices.

We intend to seek to raise additional capital from time to time if we determine that it is in our best interests and the best interests of our stockholders, including through public offerings of our stock. The net proceeds of any offering could represent a significant increase in our equity. Depending on the amount of leverage that we use, the full investment of the net proceeds of any offering might result in a substantial increase in our total assets. There can be no assurance that we will be able to invest all of such additional funds in mortgage-backed securities at favorable prices. We may not be able to acquire enough mortgage-backed securities to become fully invested after an offering, or we may have to pay more for mortgage-backed securities than we have historically. In either case, the return that we earn on stockholders’ equity may be reduced.

We have not established a minimum dividend payment level and there are no assurances of our ability to pay dividends in the future.

We intend to pay quarterly dividends and to make distributions to our stockholders in amounts such that all or substantially all of our taxable income in each year, subject to certain adjustments, is distributed. This, along with other factors, should enable us to qualify for the tax benefits accorded to a REIT under the Code. We have not established a minimum dividend payment level and our ability to pay dividends may be adversely affected by the risk factors described in this quarterly report on Form 10-Q. All distributions will be made at the discretion of our board of directors and will depend on our earnings, our financial condition, maintenance of our REIT status and such other factors as our board of directors may deem relevant from time to time. There are no assurances of our ability to pay dividends in the future.

If we raise additional capital, our earnings per share and dividends per share may decline since we may not be able to invest all of the new capital during the quarter in which additional shares are sold and possibly the entire following calendar quarter.

We may incur excess inclusion income that would increase the tax liability of our stockholders.

In general, dividend income that a tax-exempt entity receives from us should not constitute unrelated business taxable income as defined in Section 512 of the Code. If we realize excess inclusion income and allocate it to stockholders, this income cannot be offset by net operating losses. If the stockholder was a tax-exempt entity, then this income would be fully taxable as unrelated business taxable income under Section 512 of the Code. If the stockholder was foreign, then it would be subject to federal income tax withholding on this income without reduction pursuant to any otherwise applicable income-tax treaty.

Excess inclusion income could result if we held a residual interest in a REMIC. Excess inclusion income also would be generated if we were to issue debt obligations with two or more maturities and the terms of the payments on these obligations bore a relationship to the payments that we received on our mortgage-backed securities securing those debt obligations. We generally structure our borrowing arrangements in a manner designed to avoid generating significant amounts of excess inclusion income. We do, however, enter into various repurchase agreements that have differing maturity dates and afford the lender the right to sell any pledged mortgage securities if we default on our obligations. The IRS may determine that these borrowings give rise to excess inclusion income that should be allocated among stockholders. Furthermore, some types of tax-exempt entities, including, without limitation, voluntary employee benefit associations and entities that have borrowed funds to acquire their shares of our common stock, may be required to treat a portion of or all of the dividends they may receive from us as unrelated business taxable income. We also invest in equity securities of other REITs. If we were to receive excess inclusion income from another REIT, we may be required to distribute the excess inclusion income to our stockholders, which may result in the recognition of unrelated business taxable income.

Our charter does not permit ownership of over 9.8% of our common or preferred stock and attempts to acquire our common or preferred stock in excess of the 9.8% limit are void without prior approval from our board of directors.

For the purpose of preserving our REIT qualification and for other reasons, our charter prohibits direct or constructive ownership by any person of more than 9.8% of the lesser of the total number or value of the outstanding shares of our common stock or more than 9.8% of the outstanding shares of our preferred stock. Our charter’s constructive ownership rules are complex and may cause the outstanding stock owned by a group of related individuals or entities to be deemed to be constructively owned by one individual or entity. As a result, the acquisition of less than 9.8% of the outstanding stock by an individual or entity could cause that individual or entity to own constructively in excess of 9.8% of the outstanding stock, and thus be subject to our charter’s ownership limit. Any attempt to own or transfer shares of our common or preferred stock in excess of the ownership limit without the consent of the board of directors shall be void, and will result in the shares being transferred by operation of law to a charitable trust. Our board of directors has granted Lloyd McAdams, our President, Chairman and Chief Executive Officer, and his family members an exemption from the 9.8% ownership limitation as set forth in our charter documents. This exemption permits Lloyd McAdams, Heather Baines and Joseph McAdams collectively to hold up to 19% of our outstanding shares.

Because provisions contained in Maryland law, our charter and our bylaws may have an anti-takeover effect, investors may be prevented from receiving a “control premium” for their shares.

Provisions contained in our charter and bylaws, as well as Maryland corporate law, may have anti-takeover effects that delay, defer or prevent a takeover attempt, which may prevent stockholders from receiving a “control premium” for their shares. For example, these provisions may defer or prevent tender offers for our common stock or purchases of large blocks of our common stock, thereby limiting the opportunities for our stockholders to receive a premium for their common stock over then-prevailing market prices. These provisions include the following:

•

Ownership limit. The ownership limit in our charter limits related investors, including, among other things, any voting group, from acquiring over 9.8% of our common stock without our permission.

•

Preferred stock. Our charter authorizes our board of directors to issue preferred stock in one or more classes and to establish the preferences and rights of any class of preferred stock issued. These actions can be taken without soliciting stockholder approval.

•

Maryland business combination statute. Maryland law restricts the ability of holders of more than 10% of the voting power of a corporation’s shares to engage in a business combination with the corporation.

•

Maryland control share acquisition statute. Maryland law limits the voting rights of “control shares” of a corporation in the event of a “control share acquisition.”

Issuances of large amounts of our stock could cause the price of our stock to decline.

We may issue additional shares of common stock or shares of preferred stock that are convertible into common stock. If we issue a significant number of shares of common stock or convertible preferred stock in a short period of time, there could be a dilution of the existing common stock and a decrease in the market price of the common stock.

Future offerings of debt securities, which would be senior to our common stock upon liquidation, or equity securities, which would dilute our existing stockholders and may be senior to our common stock for the purposes of dividend distributions, may adversely affect the market price of our common stock.

In the future, we may attempt to increase our capital resources by making additional offerings of debt or equity securities, including commercial paper, medium-term notes, senior or subordinated notes and classes of preferred stock or common stock. Upon liquidation, holders of our debt securities and shares of preferred stock and lenders with respect to other borrowings will receive a distribution of our available assets prior to the holders of our common stock. Our preferred stock, if issued, may have a preference on dividend payments that could limit our ability to make a dividend distribution to the holders of our common stock. Because our decision to issue securities in any future offering will depend on market conditions and other factors beyond our control, we cannot predict or estimate the amount, timing or nature of our future offerings. Thus, our stockholders bear the risk of our future offerings reducing the market price of our common stock.

Item 3. Qualitative and Quantitative Disclosures About Market Risk

We seek to manage the interest rate, market value, liquidity, prepayment and credit risks inherent in all financial institutions in a prudent manner designed to insure our longevity while, at the same time, seeking to provide an opportunity for stockholders to realize attractive total rates of return through ownership of our common stock. While we do not seek to avoid risk completely, we do seek, to the best of our ability, to assume risk that can be quantified from historical experience, to actively manage that risk, to earn sufficient compensation to justify taking those risks and to maintain capital levels consistent with the risks we undertake.

Interest Rate Risk

We primarily invest in adjustable-rate, hybrid and fixed-rate mortgage-backed securities. Hybrid mortgages are adjustable-rate mortgages that have a fixed interest rate for an initial period of time (typically three years or greater) and then convert to an adjustable-rate for the remaining loan term. Our debt obligations are generally repurchase agreements of limited duration that are periodically refinanced at current market rates.

Adjustable-rate mortgage-backed assets are typically subject to periodic and lifetime interest rate caps that limit the amount an adjustable-rate mortgage-backed securities’ interest rate can change during any given period. Adjustable-rate mortgage securities are also typically subject to a minimum interest rate payable. Our borrowings are not subject to similar restrictions. Hence, in a period of increasing interest rates, interest rates on our borrowings could increase without limitation, while the interest rates on our mortgage-related assets could be limited. This problem would be magnified to the extent we acquire mortgage-backed securities that are not fully indexed. Further, some adjustable-rate mortgage-backed securities may be subject to periodic payment caps that result in some portion of the interest being deferred and added to the principal outstanding. These factors could lower our net interest income or cause a net loss during periods of rising interest rates, which would negatively impact our liquidity, net income and our ability to make distributions to stockholders.

We fund the purchase of a substantial portion of our adjustable-rate mortgage-backed debt securities with borrowings that have interest rates based on indices and repricing terms similar to, but of somewhat shorter maturities than, the interest rate indices and repricing terms of our mortgage assets. Thus, we anticipate that in most cases the interest rate indices and repricing terms of our mortgage assets and our funding sources will not

be identical, thereby creating an interest rate mismatch between assets and liabilities. During periods of changing interest rates, such interest rate mismatches could negatively impact our net interest income, dividend yield and the market price of our common stock.

Most of our adjustable-rate assets are based on the one-year constant maturity treasury rate and our debt obligations are generally based on LIBOR. These indices generally move in the same direction, but there can be no assurance that this will continue to occur.

Our adjustable-rate mortgage-backed securities and borrowings reset at various different dates for the specific asset or obligation. In general, the repricing of our debt obligations occurs more quickly than on our assets. Therefore, on average, our cost of funds may rise or fall more quickly than does our earnings rate on the assets.

Further, our net income may vary somewhat as the spread between one-month interest rates and six- and twelve-month interest rates varies.

As of September 30, 2003, our mortgage-backed securities and borrowings will prospectively reprice based on the following time frames (dollar amounts in thousands):

		Assets				Borrowings
		Amount		Percentage of Total Investments		Amount		Percentage of Total Borrowings
		(amounts in thousands)
Investment Type/Rate Reset Dates:
Fixed-Rate Investments		$	404,935	10.9	%	$	—	—
Adjustable-Rate Investments/ Obligations:
Less than 3 months	��		239,564	6.5	%		233,880	7.1	%
Greater than 3 months and less than 1 year			816,888	22.0	%		2,543,504	77.3	%
Greater than 1 year and less than 2 years			582,275	15.7	%		514,350	15.6	%
Greater than 2 years and less than 3 years			1,506,249	40.6	%		—	—
Greater than 3 years and less than 5 years			159,952	4.3	%		—	—

Total		$	3,709,863	100	%	$	3,291,734	100	%

Market Value Risk

All of our mortgage-backed securities are classified as available-for-sale assets. As such, they are reflected at fair value (i.e., market value) with the adjustment to amortized costs reflected as part of accumulated other comprehensive income that is included in the equity section of our balance sheet. The market value of our assets can fluctuate due to changes in interest rates and other factors. Losses on securities classified as available-for-sale which are determined by management to be other than temporary in nature are reclassified from accumulated other comprehensive income to general operations.

Liquidity Risk

Our primary liquidity risk arises from financing long-maturity mortgage-backed securities with short-term debt. The interest rates on our borrowings generally adjust more frequently than the interest rates on our adjustable-rate mortgage-backed securities. For example, at September 30, 2003, our adjustable-rate mortgage-backed securities had a weighted average term to next rate adjustment of approximately 21 months, while our borrowings had a weighted average term to next rate adjustment of 276 days. Accordingly, in a period of rising interest rates, our borrowing costs will usually increase faster than our interest earnings from mortgage-backed securities. As a result, we could experience a decrease in net income or a net loss during these periods. Our assets that are pledged to secure short-term borrowings are high-quality, liquid assets. As a result, we have not had difficulty rolling over our short-term borrowings as they mature. There can be no assurance that we will always be able to roll over our short-term debt.

At September 30, 2003, we had unrestricted cash of $116,000 available to meet margin calls on short-term borrowings that could be caused by asset value declines or changes in lender collateralization requirements.

Prepayment Risk

Prepayments are the full or partial repayment of principal prior to the original term to maturity of a mortgage loan and typically occur due to refinancing of mortgage loans. Prepayment rates on mortgage-related securities vary from time to time and may cause changes in the amount of our net interest income. Prepayments of adjustable-rate mortgage loans usually can be expected to increase when mortgage interest rates fall below the then-current interest rates on such loans and decrease when mortgage interest rates exceed the then-current interest rate on such loans, although such effects are not predictable. Prepayment experience also may be affected by the conditions in the housing and financial markets, general economic conditions and the relative interest rates on fixed-rate and adjustable-rate mortgage loans underlying mortgage-backed securities. The purchase prices of mortgage-backed securities are generally based upon assumptions regarding the expected amounts and rates of prepayments. Where slow prepayment assumptions are made, we may pay a premium for mortgage-backed securities. To the extent such assumptions differ from the actual amounts of prepayments, we could experience reduced earnings or losses. The total prepayment of any mortgage-backed securities purchased at a premium by us would result in the immediate write-off of any remaining capitalized premium amount and a reduction of our net interest income by such amount. Finally, in the event that we are unable to acquire new mortgage-backed securities to replace the prepaid mortgage-backed securities, our financial condition, cash flows and results of operations could be harmed.

We often purchase mortgage-backed securities that have a higher interest rate than the market interest rate at the time. In exchange for this higher interest rate, we must pay a premium over par value to acquire these securities. In accordance with accounting rules, we amortize this premium over the term of the mortgage-backed security. As we receive repayments of mortgage principal, we amortize the premium balances as a reduction to our income. If the mortgage loans underlying a mortgage-backed security were prepaid at a faster rate than we anticipate, we would amortize the premium at a faster rate. This would reduce our income.

Tabular Presentation

The information presented in the table below projects the impact of sudden changes in interest rates on our annual projected net income and net assets as more fully discussed below based on investments in place on September 30, 2003, and includes all of our interest-rate sensitive assets and liabilities. We acquire interest-rate sensitive assets and fund them with interest-rate sensitive liabilities. We generally plan to retain such assets and the associated interest rate risk to maturity.

Change in Interest Rates	Percentage Change in Net Interest Income	Percentage Change in Net Assets
-2.0%	-89.7%	0.9%
-1.0%	-49.7%	1.1%
0%	—	—
1.0%	21.8%	-1.9%
2.0%	20.0%	-4.4%

Many assumptions are made to present the information in the above table, as such, there can be no assurance that assumed events will occur or that other events will not occur that would affect the outcomes; therefore, the above table and all related disclosures constitute forward-looking statements. The analysis presented utilizes assumptions and estimates based on management’s judgment and experience. Furthermore, future sales, acquisitions and restructuring could materially change our interest rate risk profile.

The table quantifies the potential changes in net income and net asset value should interest rates immediately change (are “shocked”). The results of interest rate shocks of plus and minus 100 and 200 basis points are presented. The cash flows associated with the portfolio of mortgage-backed securities for each rate shock are calculated based on a variety of assumptions, including prepayment speeds, time until coupon reset, yield on future acquisitions, slope of the yield curve and size of the portfolio. Assumptions made on the interest-rate sensitive liabilities, which are repurchase agreements, include anticipated interest rates (no negative rates are utilized), collateral requirements as a percent of the repurchase agreement and amount of borrowing. Assumptions made in calculating the impact on net asset value of interest rate shocks include interest rates, prepayment rates and the yield spread of mortgage-backed securities relative to prevailing interest rates.

Our asset/liability structure is generally such that a decrease in interest rates would be expected to result in an increase to net interest income, as our cost of funds are generally shorter term than our interest earning assets. Nevertheless, given the impact of prepayment assumptions and other assumptions, coupled with the low level of interest rates at September 30, 2003, the interest rate shocks presented in the above table would cause net income to decrease under each of the declining interest rate shock scenarios presented. When interest rates are shocked, prepayment assumptions are adjusted based on management’s best estimate of the effects of changes in interest rates on prepayment speeds. For example, under current market conditions, a 100 basis point decline in interest rates is estimated to result in a 65% increase in the prepayment rate of our mortgage-backed securities portfolio. The base interest rate scenario assumes interest rates at September 30, 2003. Actual results could differ significantly from those estimated in the table.

Item 4. Controls and Procedures

(a) We carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-14(c) and Rule 15b-14(c) of the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this report. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective in timely alerting them to material information relating to us required to be included in our periodic SEC filings.

(b) There has been no change in our internal controls over financial reporting during the fiscal quarter covered by this report that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Part II. OTHER INFORMATION

Item 1. Legal Proceedings

We are not a party to any material pending legal proceedings.

Item 2. Changes in Securities and Use of Proceeds

(a) None

(b) None

(d) None

Item 3. Defaults Upon Senior Securities

None

Item 4. Submission of Matters to a Vote of Security Holders

None

Item 5. Other Information

On October 15, 2003, we declared a dividend of $0.33 per share which was paid on November 10, 2003 to holders of record as of the close of business on October 30, 2003.

On August 18, 2003, we completed a follow-on offering of our common stock. We issued 4,025,000 shares of common stock pursuant to a public offering at a price of $14.30 per share and received net proceeds of $54.7 million, net of underwriting discount of $0.715 per share and other offering expenses.

Item 6. Exhibits and Reports on Form 8-K

(a)Exhibits. The following exhibits are either filed herewith or incorporated herein by reference:

Exhibit Number		Description

3.1	(1)	Amended Articles of Incorporation

3.2	(2)	Articles of Amendment

3.3	(1)	Bylaws

4.1	(1)	Specimen Common Stock certificate

4.2	(3)	Specimen Preferred Stock certificate

10.1	(2)	1997 Stock Option and Awards Plan, as amended

10.2	(4)	2002 Dividend Reinvestment and Stock Purchase Plan

10.3	(5)	2002 Incentive Compensation Plan

10.4	(5)	Agreement and Plan of Merger dated April 18, 2002 by and among Anworth Mortgage Asset Corporation (“Anworth”), Anworth Mortgage Advisory Corporation (the “Manager”) and the shareholder of the Manager

Exhibit Number		Description

10.5	(6)	Employment Agreement dated January 1, 2002, between the Manager and Lloyd McAdams

10.6	(6)	Employment Agreement dated January 1, 2002, between the Manager and Heather U. Baines

10.7	(6)	Employment Agreement dated January 1, 2002, between the Manager and Joseph E. McAdams

10.8	(6)	Addendum to Employment Agreement dated April 18, 2002, among Anworth, the Manager and Lloyd McAdams

10.9	(6)	Addendum to Employment Agreement dated April 18, 2002, among Anworth, the Manager and Heather U. Baines

10.10	(6)	Addendum to Employment Agreement dated April 18, 2002, among Anworth, the Manager and Joseph E. McAdams

10.11	(6)	Second Addendum to Employment Agreement dated as of June 13, 2002 by and among Anworth and Joseph E. McAdams

10.12	(6)	Sublease dated June 13, 2002, between Anworth and Pacific Income Advisers, Inc.

10.13	(7)	Amendment to Sublease dated July 8, 2003 between Anworth and Pacific Income Advisers, Inc.

10.14	(8)	Administrative Agreement dated October 14, 2002, between Anworth and Pacific Income Advisers, Inc.

10.15	(9)	Sales Agreement dated December 30, 2002, between Anworth and Cantor Fitzgerald & Co.

10.16	(10)	Amendment to Sales Agreement dated January 10, 2003, between Anworth and Cantor Fitzgerald & Co.

10.17	(10)	Deferred Compensation Plan

10.18		BT Management Company, L.L.C. (“BT Management”) Operating Agreement dated November 3, 2003

10.19		Management Agreement dated November 3, 2003 between BT Management and Belvedere Trust Mortgage Corporation

10.20		Employment Agreement dated November 3, 2003 between BT Management and Claus Lund

10.21		Employment Agreement dated November 3, 2003 between BT Management and Russell J. Thompson

31.1		Certification of the Chief Executive Officer provided pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2		Certification of the Chief Financial Officer provided pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1		Certifications of the Chief Executive Officer provided pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

32.2		Certifications of the Chief Financial Officer provided pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

(1)

Incorporated by reference from our Registration Statement on Form S-11, Registration No. 333-38641, which became effective under the Securities Act of 1933, as amended (the “Act”), on March 12, 1998.

(2)

Incorporated by reference from our Definitive Proxy Statement filed pursuant to Section 14(a) of the Securities Exchange Act of 1934, as filed with the Securities and Exchange Commission on May 14, 2003.

(3)

Incorporated by reference from our Registration Statement on Form S-3, Registration No. 333-85036, which became effective under the Act on June 13, 2002.

(4)

Incorporated by reference from our Registration Statement on Form S-3, Registration No. 333-91480, which became effective under the Act on July 3, 2002.

(5)

Incorporated by reference from our Definitive Proxy Statement filed pursuant to Section 14(a) of the Securities Exchange Act of 1934, as filed with the Securities Exchange Commission on May 17, 2002.

(6)

Incorporated by reference from our Quarterly Report on Form 10-Q for the quarter ended June 30, 2002, as filed with the Securities and Exchange Commission on August 14, 2002.

(7)

Incorporated by reference from our Quarterly Report on Form 10-Q for the quarter ended June 30, 2003, as filed with the Securities and Exchange Commission on August 8, 2003.

(8)

Incorporated by reference from our Quarterly Report on Form 10-Q for the quarter ended September 30, 2002, as filed with the Securities and Exchange Commission on November 14, 2002.

(9)

Incorporated by reference from our Post-Effective Amendment No. 1 to our Registration Statement on Form S-3, Registration No. 333-99005, which became effective on January 14, 2003.

(10)

Incorporated by reference from our Annual Report on Form 10-K for the year ended December 31, 2002, as filed with the Securities and Exchange Commission on March 26, 2003.

(b)Reports on Form 8-K. We filed the following current reports on Form 8-K during the quarter ended September 30, 2003:

•

On July 17, 2003, we furnished, but did not file, a Current Report on Form 8-K to announce the issuance of our press release that addressed our second quarter 2003 results.

•

On August 13, 2003, we filed a Current Report on Form 8-K to file an underwriting agreement relating to the sale of 4,025,000 shares of our common stock, including 525,000 shares subject to a 30-day option granted to the underwriters to cover over-allotments.

•

On September 19, 2003, we furnished, but did not file, a Current Report on Form 8-K to announce the issuance of our press release that addressed an earnings update for our third quarter 2003 results.

SIGNATURES

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

		ANWORTH MORTGAGE ASSET CORPORATION

		/s/ JOSEPH LLOYD MCADAMS
		Joseph Lloyd McAdams Chairman of the Board, President and Chief Executive Officer (authorized officer of registrant)
Dated: November 12, 2003

		/s/ THAD M. BROWN
		Thad M. Brown Chief Financial Officer (principal accounting officer)
Dated: November 12, 2003

INDEX TO EXHIBITS

Exhibit Number		Description

3.1	(1)	Amended Articles of Incorporation

3.2	(2)	Articles of Amendment

3.3	(1)	Bylaws

4.1	(1)	Specimen Common Stock certificate

4.2	(3)	Specimen Preferred Stock certificate

10.1	(2)	1997 Stock Option and Awards Plan, as amended

10.2	(4)	2002 Dividend Reinvestment and Stock Purchase Plan

10.3	(5)	2002 Incentive Compensation Plan

10.4	(5)	Agreement and Plan of Merger dated April 18, 2002 by and among Anworth Mortgage Asset Corporation (“Anworth”), Anworth Mortgage Advisory Corporation (the “Manager”) and the shareholder of the Manager

10.5	(6)	Employment Agreement dated January 1, 2002, between the Manager and Lloyd McAdams

10.6	(6)	Employment Agreement dated January 1, 2002, between the Manager and Heather U. Baines

10.7	(6)	Employment Agreement dated January 1, 2002, between the Manager and Joseph E. McAdams

10.8	(6)	Addendum to Employment Agreement dated April 18, 2002, among Anworth, the Manager and Lloyd McAdams

10.9	(6)	Addendum to Employment Agreement dated April 18, 2002, among Anworth, the Manager and Heather U. Baines

10.10	(6)	Addendum to Employment Agreement dated April 18, 2002, among Anworth, the Manager and Joseph E. McAdams

10.11	(6)	Second Addendum to Employment Agreement dated as of June 13, 2002 by and among Anworth and Joseph E. McAdams

10.12	(6)	Sublease dated June 13, 2002, between Anworth and Pacific Income Advisers, Inc.

10.13	(7)	Amendment to Sublease dated July 8, 2003 between Anworth and Pacific Income Advisers, Inc.

10.14	(8)	Administrative Agreement dated October 14, 2002, between Anworth and Pacific Income Advisers, Inc.

10.15	(9)	Sales Agreement dated December 30, 2002, between Anworth and Cantor Fitzgerald & Co.

10.16	(10)	Amendment to Sales Agreement dated January 10, 2003, between Anworth and Cantor Fitzgerald & Co.

10.17	(10)	Deferred Compensation Plan

10.18		BT Management Company, L.L.C. (“BT Management”) Operating Agreement dated November 3, 2003

10.19		Management Agreement dated November 3, 2003 between BT Management and Belvedere Trust Mortgage Corporation

10.20		Employment Agreement dated November 3, 2003 between BT Management and Claus Lund

10.21		Employment Agreement dated November 3, 2003 between BT Management and Russell J. Thompson

31.1		Certifications of the Chief Executive Officer provided pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

Exhibit Number		Description

31.2		Certifications of the Chief Financial Officer provided pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1		Certifications of the Chief Executive Officer provided pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

32.2		Certifications of the Chief Financial Officer provided pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

(1)

(2)

(3)

Incorporated by reference from our Registration Statement on Form S-3, Registration No. 333-85036, which became effective under the Act on June 13, 2002.

(4)

Incorporated by reference from our Registration Statement on Form S-3, Registration No. 333-91480, which became effective under the Act on July 3, 2002.

(5)

Incorporated by reference from our Definitive Proxy Statement filed pursuant to Section 14(a) of the Securities Exchange Act of 1934, as filed with the Securities Exchange Commission on May 17, 2002.

(6)

Incorporated by reference from our Quarterly Report on Form 10-Q for the quarter ended June 30, 2002, as filed with the Securities and Exchange Commission on August 14, 2002.

(7)

Incorporated by reference from our Quarterly Report on Form 10-Q for the quarter ended June 30, 2002, as filed with the Securities and Exchange Commission on August 8, 2002.

(7)

Incorporated by reference from our Quarterly Report on Form 10-Q for the quarter ended September 30, 2002, as filed with the Securities and Exchange Commission on November 14, 2002.

(8)

Incorporated by reference from our Post-Effective Amendment No. 1 to our Registration Statement on Form S-3, Registration No. 333-99005, which became effective on January 14, 2003.

(9)

Incorporated by reference from our Annual Report on Form 10-K for the year ended December 31, 2002, as filed with the Securities and Exchange Commission on March 26, 2003.

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Anworth Mortgage Asset (RC+C) 10-Q2003 Q3 Quarterly report

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