Q3 2005 Thornburg Mortgage Inc. Earnings Conference Call - Final OPERATOR:

Good morning ladies and gentlemen. Thank you for standing by. Welcome to the third-quarter earnings conference call. At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session. Instructions will be given at that time. If you should require assistance during the call please press star and then zero. As a reminder this conference is being recorded. Certain matters discussed in this conference call may constitute forward-looking statements within the meaning of the federal security laws. Actual results and the timing of certain events could differ materially from those projected or/and contemplated by the forward-looking statements due to a number of factors including general economic conditions; interest rates; the availability of ARM securities and loans for acquisition; and other risk factors outlined in the Company's SEC reports and the annual report on Form 10-K. I would now like to turn conference over to our host President and Chief Operating Officer Mr. Larry Goldstone and the Chief Financial Officer Mr. Clay Simmons. Please go ahead. LARRY GOLDSTONE COO THORNBURG MORTGAGE INC.:

Thank you Operator. Good morning everyone and unfortunately -- just to be clear this is the Thornburg Mortgage earnings call for any of you who might be on the call who didn't -- who thought you were joining Boeing Airlines or somebody else. Anyway good morning everyone. Last evening after the close of the market Thornburg Mortgage announced a very very good third quarter. We reported net income of 74 -- oh actually I'm sorry let me stop for a second. We are webcasting this presentation or this conference call. Also on our website there are a series of slides that present graphical information Powerpoint-based information related to this call and I am going to be referencing those slides as we go through this presentation. And you can get there by going to www.thornburgmortgage.com and clicking on our Investor site -- section of our site and then you will find the conference call slides available there. So I am going to be starting with Slide 3 for those of you who might be following along with those slides as well. So with that little introduction again as I said we reported net income of $74 million for the quarter up 28% from the same quarter last year. That translates into earnings per share of $0.70 per share versus $0.69 per share one year ago. That was about $0.02 better than the consensus estimate of $0.68 for the quarter. We had notably no asset sales or gain on sale contributing to earnings in this quarter and we had minimal equity capital raising during the quarter as well. So this is quite a notable quarter for the Company and we are going to talk in some detail about just exactly why although I think [inaudible--audio interference] -- it is fair to say that we laid out or indicated that we would be pursuing some strategies at the end of the second quarter that we thought would be helpful from an earnings perspective in the third quarter and I am happy to report that those strategies proved quite successful. The Board of Directors elected to maintain the dividend at $0.68 a share; that's up 1% from where it was a year ago but again it is constant at $0.68. And I guess I also want to mention that we continue to have a reserve of undistributed taxable income of approximately $0.33 per share which we could use if we needed to in order to provide some support for the dividend but we don't -- we did not need to dip into that reserve during the current quarter and quite honestly for a reasonable range of interest rate outlooks we don't anticipate that we are going to have to use that undistributed taxable income going forward. Some other highlights for the quarter. Total assets ended the quarter at $39.6 billion; that is 50% growth in assets on a year-over-year basis so no doubt we are growing. We had a very good quarter for loan origination activity.

Despite the fact that the yolk curve is flattening and there seems to be an increased preference for consumers to opt for 15-year and 30-year fixed rate mortgages and the shorter adjusting one-month and six-month and one-year arms have fallen out of favor we were still able to have or originate $1.3 billion worth of loans during the quarter; that's up about 10% from a year ago. Book value per share was $21.09; that's 11% growth on a year-to-year basis. And the credit quality or our loan orig -- of our loans that we've originated continues to be very good; 8-basis points of 60-plus days delinquent loans that's unchanged from prior quarters. If you will turn to Slide 4 in the presentation materials the environment definitely is and has been a challenge. I am not going to sit here and whine about how difficult the environment is; rather I think the Company is embracing the challenge and we definitely feel that we have answers and responses and solutions to help us navigate through this environment hopefully with relatively stable earnings and an unchanged dividend which I think is going to be some surprise to a lot of folks out there. But up to this point in time with the Fed having raised interest rates eleven times and total rate increases of 275-basis points our earnings continue to perform exceptionally well although not a big surprise to us quite frankly given the fact that we actively manage interest rate risk. We do anticipate that the Fed is going to continue to raise interest rates.

We like anybody else don't know exactly how far they are going to go but I would say that we are prepared for a Fed funds rate in the 4.5% to 5% range by the end of the year 2006. So that would certainly be within our range and realm of expectation. The yield curve continues to flatten there as well as short rates continue to increase. That does have a couple of impacts on us. It does have some minor impact on the liability costs that we are paying out there relative to the assets and we also think that it feeds into -- or makes the mortgage environment slightly more competitive than it otherwise would have been but clearly the environment in the mortgage business is very competitive. Mortgage products are performing very well from a liquidity a total return and a risk perspective and consequently there is a lot of competition from mortgage assets out there. So spreads while not necessarily getting a whole lot tighter in here are certainly at the tight end of the range relative to where they have been over the last five or six years. Also adding to the competitive pressure is the fact that some lenders out there continue to ease credit standards. Interest -- mortgage products like the option ARM and stated income lending or low dock and no dock lending all-day lending are all basically competing away some segments of what would traditionally be the prime space. I think we are doing quite well from an origination perspective but it is also a factor out there. And lastly borrowers are opting for longer dated mortgage products.

The share for adjustable rate mortgages is down this year relative to where it was last year again because of flatness of the yield curve. But I think our product menu appears to be offsetting that and again we're doing a nice job of originating and growing our loan origination business. If you will turn to Slide 5 we have and continue to see some margin compression. Certainly that's been true over the last couple of years but I think over the last two or three quarters we are beginning to see some stabilization of that interest margin which is is a good thing. We only had a 2-basis point decline in the interest margin between the second quarter and third quarter of this year from 105-basis points to 103-basis points. But I also want to call your attention to a new metric because our margins are compressing for a variety of different reasons. There are -- there is a huge dynamic at work here some of which is being directed and led by management and some of which is being directed or led by the market and the environment in general. And so we want to focus your attention momentarily on net interest income per share because as far as the Company can tell this is probably the best single measure to sort out and segment out all of the moving parts that have an effect on our spreads.

You know higher investment spreads effected; changes in prepayment rates affect our spreads; changes in our hedging strategy effect our spreads; the issuance of CDO financing effects our spreads; the issuance of unsecured debt affects our spreads; and all these things when taken together make it very very difficult to simply look at a spread number and have some understanding of what's going on. But at the end the day management is very focused on net interest income per share because that is the amount of money first of all that we have to pay expenses and secondarily that is what falls to the bottom line after expenses in the form of net income and earnings per share. And you can see we made a notable improvement in the third quarter versus the second quarter as it relates to net income -- net interest income per share. Net interest income per share increased from $0.85 per share in the second quarter to $0.91 per share in the third quarter and again as I said I think that's the single best measure or way to segment out all the moving parts and really focus on bottom line results. So we are very pleased with that result. If you turn to Slide 7 I believe is where we would be the reason that we have had consistency in results despite the margin compression is related to a number of different factors but the single biggest reason is our ongoing disciplined approach to interest rate risk management. We have said it before we will say it again: we are not lending long and borrowing short. The fact that the Federal Reserve is raising interest rates the fact that short-term interest rates are going up is having some effect but that effect is greatly minimized by the fact that we are actively borrowing fixed rate and long-term hedged financing roughly $33 billion dollars of hedged financing as of the end of the quarter. 93% of the hybrid portfolio is funded with fixed-rate borrowings. Those interest rates are not changing as short-term rates increase. Our portfolio GAAP and hybrid duration GAAP as the end of the fourth quarter was four months; that's up from three months in the last quarter so not a significant change in duration. We are continuing to actively manage our interest rate risk exposure. And I think the other thing I will mention and it is not really clear from our earnings release for the first quarter this quarter we are now beginning to see a positive cash flow benefit from our interest rate swap transactions. In other words we are paying a fixed rate of interest in receiving a floating rate of interest and this is the first quarter where that floating rate pay/receive side is actually greater than the fixed rate that we are paying. So our funding costs are definitely being fixed and we are beneficiary from this point forward as interest rates continue to rise. The other thing I will note is the fact that this has not been an inexpensive process. This is all about generating stability in earnings and dividends through time. We clearly could have made more money if we weren't hedging our portfolio but the volatility of the stock price and the volatility of earnings would have been substantially different. So our hedging and interest rate risk management practices are proving very successful. If you turn to Slide 8 I think this is the slide that very clearly documents or illustrates how much of the duration or interest rate risk -- seven I thought we changed all the numbers? I am on track now? This definitely shows the change in the -- or the elimination of volatility in the duration of our portfolio versus an unhedged hybrid ARM portfolio.

We are actively managing this risk and we are managing it through time and you can see we have had very consistently low duration under six months for the last couple of years now. I think a second component that contributed to the success of our quarter and continues to our earnings stability is the fact that we have very little exposure or minimal exposure to changes in prepayment rates and that's because we have focused over the years -- so which slide is this then? Okay. So Slide 8. If you refer to Slide 8 a little exposure to prepayments. You can see going back to 1998 we have been very consistently and in a disciplined fashion been trying to reduce the cost basis of our assets. Today we own our assets. It is slightly under a 1% premium to par. As a result the 27.7% prepayment rate which was up from the prior quarter really didn't cause us much of a change in terms of the amortization rate on our portfolio. So again prepayments are not having a huge impact on earnings volatility for the Company. Our -- if you refer to Slide 9 our credit quality continues to be very good; 98% plus of our assets in our portfolio are rated AA or AAA by Moody's or Standard & Poor's 49% of that portfolio being what we call purchased ARM securities 33% of that portfolio being -- or of those double AA/AAA rated assets being our own securitized loans and 17% is a new category that we are breaking out for the first time on our balance sheet this quarter which are what we are calling purchased securitized loans. These will be loans that we have acquired from others that were in securitized form and we own all the classes of those securities. If you refer to Slide 10 our borrower profile on our own originated assets continues to be exceptionally good: average loan size now slightly in excess of $500 000; very low loan-to-value ratios; high FICO scores; very strong borrowers with good incomes and low debt ratios and 47 years of age meaning they are not "spring chickens " they are very experienced well established homeowners. So our borrower profile continues to be very good and if you turn to Slide 11 our credit performance continues to be exceptional as well. We had 8-basis points of 60-plus day delinquent loans on our $13 billion originated loan portfolio in the quarter. That is unchanged from the prior quarter. We had no loan losses during the quarter and no loan losses in the last 15 quarters so that trend continues to be very positive. And our delinquency statistics are substantially below National averages; 173-basis points of 60-plus day delinquent loans for all conventional ARM loans and 57-basis points of delinquencies nationally on prime loans. So we are doing a much better job than the industry as a whole. Just a brief note here on hurricanes Katrina and Rita. We are in the process and have been continuously in the process since those hurricanes occurred of trying to assess any potential exposure or losses that we might have up to this point in time. While we can't exactly quantify the losses we don't believe that we have a significant number of properties -- I think we have six with damage and maybe a couple of others with a little bit more damage from Hurricane Katrina but at the end of the day we don't think that there is any loss exposure from hurricanes Katrina or Rita. During the quarter I also would say that we -- we got a pretty good earnings benefit from better utilization of our capital. We raised during the quarter $63 million of preferred equity. Actually in the second quarter we had $63 million of preferred equity that we raised and we did a $1.6 billion CDO transaction. Both of those transactions in the second quarter were contributors to our earnings in the third quarter because we had the new assets on the books that we were able to generate out of those transactions during the third quarter. And additionally as I indicated earlier and as I indicated in the second quarter conference call we planned to increase our leverage during the third quarter and we did exactly that. I indicated that we might be adding $1.5 billion to $2 billion worth of assets to our existing capital base and that is precisely what we did; $2.1 billion actually. We had an average equity-to-assets ratio of 896 in the second quarter and 836 in the third quarter. So we are well within our policy guidelines for capital strength in our portfolio; 8% is our minimum requirement 836 is where we were for the quarter. 881 is where we ended the quarter so we actually have some more leveraging to do in the fourth quarter.

Beyond that I want to point out that our unencumbered assets as of the end of the quarter were $1.4 billion so we have a very strong liquidity position at this point in time as well. So we are very comfortable -- I guess there is one other note to make that I don't think appeared necessarily in the press release. As a result of interest rate changes during the quarter on a net basis I think we had a $15 million change in the market value of our portfolio. And so we are carrying $1.4 billion worth of excess liquidity principally as a way to protect ourselves from market value changes in our portfolio and we had a $15 million change in the quarter. But we feel very very good about our leverage position our equity capital position our liquidity position our asset quality position and I would say we are very well positioned to do well in the third quarter. I want to talk just for moment about equity capital raises. We did $66 million of equity capital raising during the quarter. It was a relatively small quarter principally done through our dividend reinvestment plan. We didn't do any other capital raising transactions during the quarter principally because the stock price did not support equity capital raising. But on average we were able to raise new equity capital at $26.82 during the quarter so that was accretive to book value to the extent that we were able to raise that common equity. But again with the stock price down where it is we had to rely on alternative long-term capital sources; preferred equity unsecured debt subordinated notes additional CDO issuance all of which allowed us to grow our balance sheet during the quarter. From the standpoint of margins and the income statement. As I said earlier net interest income was $92 million. Net income was $74 million. There was no gain on sale. We had $2.1 million in servicing income up 8% on a year-over-year basis. 14% -- actually 13.9% return on equity versus 15.2% last year. Definitely a decline in return on equity; it's a tougher market. We were also an expense -- or a beneficiary from declining expenses 22-basis points of expense on assets during the quarter down from 33-basis points on expense from assets a year ago. We are just a beneficiary and our shareholders are a beneficiary of the fact that all of our compensation or much of our compensation is formula based. If the stock price goes down if the return on equity goes down expenses go down and that helps to cushion shareholders and helps to benefit earnings during those time periods.

The portfolio yield did increase during the quarter to 4.46% as we continued to buy higher yielding assets in this environment up from 4.29% in the prior quarter; so about a 17-basis point improvement in yield. Our cost of funds though also went up 363 from 344 as we continue to hedge our portfolio; that's about a 19-basis point increase that explains the 2-basis point change in our margin for the quarter. Portfolio margin of 103-basis points; when you consider the impact of equity down just slightly from 105-basis points in the prior quarter. So we hope that bodes well for -- on a going-forward basis. Balance sheet grew by 47% year-over-year. $38.4 billion in ARM assets. $8 billion in new acquisitions during the quarter. Net portfolio growth of $5 billion for the quarter. All the new assets were acquired at a price of about par decimal 7% which explains the decline in the cost basis of our assets. We bought $5.7 billion of mortgage-backed securities in the quarter. Actually I am on Slide 12 for those of you following along. $957 million in bulk loans. And we talked about our $1.3 billion in originations earlier. Let's see. Where do we go next. Talked about that. Talked about -- well let 's talk about originations for just a moment. $1.3 billion for the third quarter up 10% from year-ago period. We are on a pace to definitely meet our $4.2 billion target for the year. We have originated year-to-date $3.6 billion. That is 11% growth in originations and again we are exclusively an adjusted rate mortgage lender. The share of adjustable rate mortgages has been declining over the course of this year and yet we are growing our originations. We think that bodes very well for our outlook for originations going forward. After adjusting for fallout our pipeline of loans that we anticipate closing in the fourth quarter totaled $890 million versus $677 million in the second quarter. So we are definitely seeing an increase in pipeline activity and we thinks that sets us up for a very good quarter of originations in the fourth quarter. Referring to Slide 14 we did complete a collateralized debt financing transaction towards the end of the third quarter for $2.7 billion. That specific transaction we estimate frees up approximately $185 million meaning that we can add another $2.1 billion in assets in the fourth quarter if we need to. This continues to be a very strong -- a very good earnings accretive transaction for the Company going forward. So we think these transactions are going to continue to help the Company. And CDO finance which is permanent financing and duration matched financing as a general rule accounts for 25% of our operating debt at the present time. Brief mention we also during the quarter -- referring to slide 16 -- is we completed a subordinated debt transaction at the end of the third quarter as well $130 million of 30-year unsecured debt with net proceeds of approximately $136 million. We locked in fixed rate financing of 7.4% for the next ten years. On an all-in effective cost basis it is going to be 7 and 5/8. This also long-term capital as far as the Company is concerned it is leveragable capital. We think we will be acquiring an additional $1.6 billion of assets with this as the capital base underlying those new asset purchases. So this should also be earnings beneficial for the Company for the company's common shareholders as we move down the road. And when you take everything together and I am referring to Slide 16 we have three different -- what we will call alternative long-term capital sources these days. We have ten-year unsecured senior notes about $305 million. We just did this $140 million subordinated debt unsecured debt financing transaction. And we have preferred stock outstanding as well which is paying a fixed route coupon of 8% for the company. Those three transactions altogether would all be considered alternatives to common equity as it relates to long-term capital. All leveragable capital and to the extent that we can earn a return on equity that is greater than -- I think the blended cost of all of that is something just under 8% or approaching 8% to the extent that we can continue to earn 12% to 13% return in equity the incremental difference between the cost of that debt and the return on equity is flowing to the bottom line as an earnings benefit for common shareholders. Let's see just a couple of concluding remarks here. We are going to continue as we have always in the past to actively manage our interest rate risk exposure and our credit exposure as we continue to matriculate through this interest rate and credit environment. We're going to continue to grow our balance sheet and we expect that we have alternative ways or better ways to continue to utilize our existing capital base. We are comfortable with the earnings per share estimates for the current year. We think we will be comfortably in the range of $2.72 to $2.80 for the year. I am not quite sure what that implies for the fourth quarter; maybe Clay can help me there in just a second. And we don't think we are looking at a significant earnings decline even if the Fed raises interest rates to 5% that would be another 125-basis point Fed funds rate increase during the course of 2006.

So we are comfortable with the dividend up to that level and even if the Fed went further than that if they went to 5.5% or 6% we have $0.33 of undistributable taxable income that we could if we needed to dip into to continue to support the dividend. So we thinks dividend stability is definitely in the cards for whole variety of interest rates outcomes even those that are greater than what's implied by forward interest rates out there. And I will remind you that once the Federal Reserve stops raising interest rates which they will do at some point in time we think that the operating environment will improve. We think that bodes very well for our outlook for earnings. We are -- as I have said in the past we are continuing to play defense in this environment as opposed to being offensive. We think there are some strategies that we could be pursuing that would be -- that are very earnings beneficial if we could get out of this flat-yield curve Fed tightening environment. We think that will happen at some point in 2006. So the upside for those of you who can be longer term than one quarter we think is very very very good. One final reminder. We are sponsoring an investor day in New York City on November 8th. Key members of the senior management team will be in New York City doing a more more detailed presentation of the various aspects of the Company's operation. We did this last year. It was very successful. And for those you who may be interested in attending I have some contact information for you. The event is being coordinated by [GA Kraut & Company] in New York City. Their phone number 212-696-5600 and you can ask to speak to either [Steve Barik or Ingrid Eisen]. They can take care of making reservations so you can attend that session. With that said I think Rachel we can open it up for questions from the audience. OPERATOR: Thank you. [OPERATOR INSTRUCTIONS]. The first question comes from the line of Paul Miller of Friedman Billings and Ramsey. Please go ahead. PAUL MILLER ANALYST FRIEDMAN BILLINGS RAMSEY GROUP INC.: Thank you very much. You know the long-term incentive awards you kind of had a -- about a what $1.7 $1.8 million reversal? I know you talked about that your salary is is performance based. Is that due to the salary decline or is that something we can expect going forward? Or that back -- go to $2 $3 million which it usually been going forward? LARRY GOLDSTONE: Well I think that it is mostly stock price dependent is what it is. We actually would estimate -- yes it is stock price dependent. That should be a positive number. I am not sure it should be $2 million or $3million but it is stock-priced dependent. And while I can't remember the specific numbers there is disclosure in the Q that can tell you exactly how many shares of stock are owned by management in the -- and the directors -- in the form of phantom stock rights that are subject to mark-to-market. But you can -- it is safe to say that that was definitely a significant reduction in management compensation because of this decline in the stock price during the quarter. CLAY SIMMONS CFO THORNBURG MORTGAGE INC.: Larry I can jump in here a little bit. It's -- there is really two components. There's the change in value of the stock. There is a little over a million shares in the program. So it would be the change in fair value of the stock would be one component and then the other component which is always an expense would be the vesting of the shares that have been granted. And the vesting expenses is around $600 000 to $700 000 a month and so kind of the -- if there were no change in the stock price it would be about a million eight a quarter. PAUL MILLER: Okay. And then one final quick question. You know when you stop down here it is obviously very difficult to do some type of equity capital ratio. What about preferred stock offering and how much room do you have in the preferred stock? LARRY GOLDSTONE: Well I think we have some room in the preferred stock. I am not sure that we necessarily need to do much preferred stock capital raising in the fourth quarter specifically. Essentially through the CDO transaction that we did at the very end of the third quarter that was the equivalent of having raised about $185 million of equity capital. And on top of that we have the $140 million or $135 million of subordinated debt. So we have about oh somewhere in excess of $300 million of capital that either we have put to work or we need to finish putting to work in the fourth quarter. So our capital position continues to be very very good. Quite frankly I suspect we could do another $50 million to $100 million of preferred stock if we chose to. I don't think that is necessarily on the radar right this minute but anything is possible during the course of the quarter. PAUL MILLER: Thank you very much Larry. LARRY GOLDSTONE: You bet. OPERATOR:

The next question comes from the line of Steve Covington of Stifel. Please go ahead. STEVE COVINGTON ANALYST STIFEL NICOLAUS: Good morning. Congratulations on a great quarter in a tough environment. LARRY GOLDSTONE: Thank you. STEVE COVINGTON: I think I saw in the slide show that the net margin on duration matched permanently funding -- funded assets is that running about 85 to 95 on new business? LARRY GOLDSTONE: Yes it is. STEVE COVINGTON: Okay. And then I guess just -- in -- it is just a more general question can you talk generally about some of the risks that are on your mind specifically for your business and then maybe also for just in the overall market? LARRY GOLDSTONE: Well I think specific to us there are probably just a couple of things that we continue to focus on. I am not sure if this is in any particular order but certainly continued diligence on the credit risk management side of the business I think is -- has been one of our hallmarks and continues to be one of our hallmarks. We continue to be a little bit concerned about the housing market. Obviously you can't pick up a newspaper these days and not read something about a potential housing bubble. So we continue to be very prudent and very committed to managing our credit risk and I think that is just something that I and others worry about on a continuing basis. It's sort of a combination of competition for mortgage assets and Fed activity. There continues to be some uncertainty there but again I think that we continue to focus our attention on making sure that we are doing a good job of managing our interest rate exposure and then maybe lastly is our liquidity position. We are a little bit higher on the leverage scale than we have been in a while. The reason that we made the decision to go there is because over the last several years we have seen remarkable stability in the market value change in our portfolio which tells us on a mark-to-market basis or on liquidation basis the Company's hedging strategies are performing extraordinary well.

But that doesn't mean that we are taking that with a grain of salt. The fact we have $1.4 billion in unencumbered assets at the end of the second quarter is a very strong number but it's something that we are paying attention to on a weekly basis and it's something that we are going to continue to pay attention to. Liquidity is probably the greatest risk that some of these companies face. Going forward for the industry it is a tough environment. I think it is not going to get any easier. I don't think the Fed is going to stop. At the current time I think we've got at least another 75-basis points of Fed tightening. Potentially some flattening in the yield curve. Potentially some increased competition for assets. Potentially tighter spreads out there. So we are continuing to -- from an environmental perspective we are trying to differentiate ourselves because I suspect there is going to be -- I suspect there's going to be more bad news from companies that we sometimes get associated with and I think that we are just trying to be -- we are different. We are manage differently. I think our earnings results support that fact very clearly. Hopefully the investment community is starting to get it and we feel very good about what we are doing. But gosh to see the stock price behave the way it has behaved over the last couple of months has been extraordinarily disappointing. And I hope that these results indicate to the investment community that we are not going the direction of a lot of other folks out there. STEVE COVINGTON: Thanks. What is your view -- just last one if I may -- what is your view on the potential for acquisitions of either people or franchises whole franchises if there is some breakage? LARRY GOLDSTONE: I think we continue to look for opportunities historically and traditionally as it relates to the growth of our business and the expansion of our business lines we have chosen the route of "build it ourselves" as opposed to "buy it from somebody else." We think that our approach to the mortgage business is unique. Most other franchises or operations we think are not cutting edge as we see cutting edge. They are not innovative enough as we see innovation. They don't get us where we want to go which is a very different way to do mortgage lending than has been traditionally done in the past. So we have chosen build it ourselves. On the other hand there is clearly some stress in the mortgage industry in general. There are some banking companies out there and some savings and loans out there that are under pressure. There are mortgage bankers that are struggling from a profitability perspective. There are other mortgage REITS out there that are struggling.

I have no idea what it is that we might do but we have a very very strong capital position here and hopefully access to equity and we will see what the opportunities are as we move forward. STEVE COVINGTON: Thanks guys. LARRY GOLDSTONE: Thank you. OPERATOR: The next question comes from the line of Scott Coren of Bear Stearns. Please go ahead. SCOTT COREN ANALYST BEAR STEARNS AND CO.: Yes hi thanks. First question just on the balance sheet if I take collateralized debt obligations and divide them by ARMs collateralizing debt obligations I get a ratio of about 103%. This seems a little bit counterintuitive. Did you pre-fund some businesses or choose not to fully fund the OC or am I missing something else there? And I have a quick follow-up thanks. LARRY GOLDSTONE: Clay you want to take that one? CLAY SIMMONS: Yes. In the most recent deal we did pre-fund a little less than $400 million of loans. We've -- I think we've got one more pledge to go and that will be completely full. So that was a good pickup. STEVE COVINGTON: Good. Thanks Clay. Second question is at the end of the quarter can you guys tell me what percentage of your ARM portfolio consisted of loans with remaining fixed periods of over five years? And then can you talk about your comfort level at managing assets with longer fixed terms like the 10-1s? LARRY GOLDSTONE: Well in the aggregate portfolio we are about 33% over five years. And what was the follow-up? STEVE COVINGTON: Just in terms of any -- as far as the mix of longer-term fixed-rate assets goes it's been increasing pretty steadily over the past twelve months. Can you just talk about your historical experience at managing these types of assets and your comfort level of continuing to increase that mix? CLAY SIMMONS: Well in terms of what we've done this year is it has been run been running about 61% of our business in 2005. Clearly there is a preference out there for the 7 and 10-year product right now. I think as -- from a management perspective we are duration matching those transactions.

Obviously the 10-1 has a little bit more negative convexity than a 3-1 or a 5-1 would have. But I think our experience has been that they perform well provided we apply the discipline when the loans go on the books. STEVE COVINGTON: Right. CLAY SIMMONS: And we continue to adjust our duration month in and month out to make sure our net duration remains in-line. STEVE COVINGTON: Thank you. And then just finally can you give us a quick update on the broker channel strategy? LARRY GOLDSTONE: It's probably going to be -- well I would say we are still in the operational and testing phase in Q4. As I have said earlier this is really going to be a 2006 initiative as opposed to 2005 initiative. We continue to be optimistic about the prospects for that business but I think that -- and you should see some announcements from the company over the next oh couple of weeks to a month as it relates to that channel. It has huge potential for us. We think it is going to have a substantial -- it is going to generate a substantial increase in our loan origination activity but as Joe Bidel has said who is our Chief Lending Officer we only get one shot. When we initiate this channel we've got to make sure that from an operational and service perspective we are on top of things and I think that is what we are working on and focused on right this minute. STEVE COVINGTON: Thanks a lot guys. LARRY GOLDSTONE: Thanks Scott. OPERATOR: Thank you. Our next question will come from the line of Don Fandetti with Citigroup. Please go ahead. DON FANDETTI ANALYST SMITH BARNEY CITIGROUP: Hi Larry. Good job in a tough market. Quick question on your guidance for '05. It implies a Q4 number of $0.60 to $0.68. It that variability just basically due to the long-term incentive comp number? LARRY GOLDSTONE: No I think it's more just a function of trying to be conservative Don. There is no sense in trying to be unrealistic or not practical about our outlook here. I think that we would like to underpromise and overdeliver if we can and there is just no reason to be -- what we are trying to in here is maintain the dividend. And we think that numbers certainly at the upper end of that range will maintain the dividend. If you press me I would have to say we are going to be towards the upper end of that range. But clearly the range is what is out there and maybe we will see some improvement in the outlook from some of the analysts as a result of the strength of this quarter both in terms of their price targets their earnings targets and their recommendations. DON FANDETTI: Larry would you expect the sort of higher quality of earnings to continue in the near term? Meaning no material gain on sale? LARRY GOLDSTONE: That would certainly be our objective yes. I think one of the things that's interesting to note and you can sort of see it pretty clearly if you go back and look at the slides that accompanied the remarks that I made earlier today is the change and the fluctuation in net interest income per share quarter-over-quarter over the last year which is the period where the Feds started raising interest rates. It is a lot easier when interest rates are stable than it is when the Fed is raising rates. So I think that it is fair to say that some fluctuation on a quarter-over-quarter basis is probably to be expected because there are a lot of moving parts that we don't have complete control of as management. But at the end of the day we think that we have got our core earnings at or very close to where we would like them.

If I had my druthers I would have our core earnings up another penny or so in the fourth quarter versus the third quarter and maybe we will get there. But yes core earnings is definitely what we are focused on. DON FANDETTI: Thanks. OPERATOR: And we have a question from the line of Paul Hamilos from AG Edwards. Please go ahead. PAUL HAMILOS ANALYST AG EDWARDS: Okay. Thank you. Just a question on the new disclosure on purchased securitized loans. Can you start by telling me what the numbers were in the first and second quarters? LARRY GOLDSTONE: Well let's see here. I have to look at -- well actually I am -- Jane Clay do we have that? You know we may have to get back to you on that. I know it was $3.5 billion at December $6.4 billion at September. My guess is that it's been -- you could probably take some midpoint estimates a third a third for the second two -- for the next two quarters. It is also disclosed in the Q so you can find it there as well. PAUL HAMILOS: Okay. And are these -- is this line item comprised of whole deals that you have bought or are these former AA or AAA securities that you had where you had essentially gone back in and bought the B pieces of these securitizations and moved them from the ARM security line to this line? LARRY GOLDSTONE: No. This is whole deals. These are basically packages of loans that we have bought from third-party sellers all prime originated. We do a significant amount of due diligence on the credit quality of the underlying assets and then they are securitized prior to us buying them and we are buying 100% of the securities. And the real -- the purpose for all of this is for us to acquire some assets that will allow us to continue to maintain our exemption from the 1940 Investment Company Act. PAUL HAMILOS: Got it. One more question. On the $2.7 billion in CDO financing that you achieved in September can you give me some sense of how much of that was composed of retail originations whole loans on your balance sheet versus securities? LARRY GOLDSTONE: There were no securities in there but I think there were some bulk purchases. Clay do you know the number of bulk purchases that went into that deal? CLAY SIMMONS: About $1.3 billion of bulk. Yes there's 1.3 billion of bulk. LARRY GOLDSTONE: So $1.3 billion of bulk and $1.3 billion of -- no actually more than a $1.3 billion of our originations right? CLAY SIMMONS: $1.45 billion. LARRY GOLDSTONE: Of our originations? CLAY SIMMONS: Yes. LARRY GOLDSTONE: Very good. PAUL HAMILOS: Okay. Excellent. Thank you. OPERATOR: And the next question comes from the line of Richard Shane with Jefferies & Company. Please go ahead. RICHARD SHANE ANALYST JEFFERIES & CO.: Good morning guys. Given the prepayment levels and also the acceleration of asset growth I am really trying to understand what's going on on the margins or at the marginal level so that we can understand where things are going going forward. You talked about the yield going from 440 to 429 to 446 Larry. How much of that is -- can you try to break that down? What is the yield on the new assets that's being added versus what is the incremental boost from things that are indexing? LARRY GOLDSTONE: I am not sure that we have that number right at our fingertips although I would say that there is not a whole lot of contribution from indexing as I think about 8% of our portfolio is traditional ARMs and those would have coupons that are rolling higher or resetting higher. But at the end of the day most of the yield -- of the increase is related to the fact that we are buying and growing in a higher yield environment. And as a result as we put new assets on the books the yield is growing. RICHARD SHANE: Got it. The other thing I would love to delve into a little bit deeper is Slides 12 and 13 which I think are very interesting.

The purchased assets you are showing a 10% to 12% ROE and the assets that you originate you are showing 13% to 15% ROE. Help us understand maybe where you are right now within that range and maybe historically what the range was. Because if I sort of take a blend on your originations and say it is 80/20 I come to an 11.5% ROE at the midpoint of those ranges which is below your current dividend payout rate. So I want to understand how long that is sustainable where you were and where you think that's going? LARRY GOLDSTONE: Well I am not so sure that we are necessarily in that. I mean I think we're probably -- well the midpoint of that range is pretty close. I think we are probably at some point in time a little bit higher. I would say those are a little bit on the conservative side but that's just the environment that we are in today. That's just the environment that we are in today. RICHARD SHANE: So realistically marginal assets are being added at 11.5% to 12% ROE? LARRY GOLDSTONE: I would say that's right yes. RICHARD SHANE: Okay. Great. Thank you very much. OPERATOR: The next question comes from the line of Diane Keefe of Pax World Funds. Please go ahead. DIANE KEEFE ANALYST PAX WORLD FUND: If you have already answered this at an earlier point in the call I apologize but I was in and out. On the subordinated debt that you took on what kind of an investor was the investor in that and can you see yourself doing more of that assuming that you can ever it up properly over time? LARRY GOLDSTONE: What kind of investor? This was a private placement transaction. I am not sure that I am really at liberty to say a whole lot about where that came from. I am just not clear on what we've agreed to say. Let's just say that the trust preferred market would be a similar type of a transaction to what we did but we have covenants in some of our debt transactions that limit our ability to issue trust-preferreds and so subordinated debt can in some cases be a substitute or a surrogate for that. And yes I do envision the possibility of us doing some more of that transaction or transactions of that type going forward. Clearly in an environment with a common stock price where it has been of late there is a more accretive earnings opportunity from the standpoint of -- what do I want to say here -- of doing alternative source of long-term capital of which this would be one of those. So yes I think there is a possibility that we could do that. DIANE KEEFE: And just a follow-up on your remarks that you had diminimus exposure to the hurricanes. Was that kind of a geographical accident in the sense that you just didn't have any large loans on the Mississippi Gulf Coast or the Louisiana Gulf Coast? Or how -- how do you -- as you looked into your portfolio and discovered it what was it that determined that you didn't have losses there? LARRY GOLDSTONE: Well I don't know if it was a geographical accident but it is true that at least as it relates to hurricane Katrina we did not have that many properties. I believe we had 82 properties in the affected area. We have already completed property inspections on all 82 of those properties and we have determined based upon our preliminary review that we have 6 properties that may have some damage. So it is not a big number. Given the fact that we are a jumbo lender it would be safe to assume that we are going to have loan concentrations in those areas of the country where higher home values reside.

From a geographical perspective California is the largest exposure that we have; New York Florida Colorado and Georgia have been the other four historically. I haven't checked the numbers recently but those are the areas where we have the most exposure. And it's really -- actually it is a function of two things: it is a function of where the larger loan sizes or the more expensive homes are and where our business partners are up to this point in time. For example we have indicated that we are making a concerted effort to grow our jumbo origination business through our correspondent lenders in the South and Midwestern sections of the country. That's a -- so I would expect over the next couple of years that you would see us increasing our lending activities in the midsection of the country everything from Dallas and Houston Texas all the way north to Chicago Illinois. That is an underrepresented segment of the country and I expect that we will increase our exposures in those -- or loans in those markets over the next year or two. DIANE KEEFE: Okay thanks. OPERATOR: And the next question comes from the line of [Richard Crebs] a private investor. Please go ahead. RICHARD CREBS (ph) PRIVATE INVESTOR: Hello there Larry. Thanks again for another great quarter. LARRY GOLDSTONE: Got it. RICHARD CREBS (ph): I definitely appreciate it. I got a couple of novice questions here. From the standpoint of our $0.33 of extra undistributed earnings is there any point in time when that has to be distributed in order to maintain the REIT status? LARRY GOLDSTONE: There is no -- no that does not have to be distributed. RICHARD CREBS (ph): Okay. That is a good answer for that one. Secondly about the Fed continuing to raise I know we are talking about throughout end of next year going to 5 and you even had some comments going past that. My real question is how important is the pace of the Fed raising should they begin to start doing 50-basis points exactly what kind of attention that may put on the portfolio and have you considered that and is it important to consider in your view? LARRY GOLDSTONE: I would say that we have not specifically considered that but we have considered the pace -- I mean we have built in some fairly substantial interest rate increases. I don't -- more at the pace of a quarter a month or a quarter every month and a half something like that. I don't think that it would have a material difference in terms of what the Fed does if in fact the pace changes. I think what is going to be more relevant is where is the stopping point. As I said we are comfortable up to 5%. I personally am not a believer that we are going to see the Fed raising at 50 to 75-basis points a quarter not where we are in this cycle. But maybe they will. I don't really know. But I think we feel again pretty insulated from that from all those factors as we go forward. RICHARD CREBS (ph): At the risk of repeating something you said as an investor I really do hope the streak begins to differentiate us a little better. It has been a rough four months for us stockholders but I really appreciate the effort and the success that you folks have put into it. LARRY GOLDSTONE: Great. Thank you. RICHARD CREBS (ph): Take care of yourself. OPERATOR: And the next question comes from the line of [Jordan Heimowitz] of Philadelphia Financial. Please go ahead. JORDAN HEIMOWITZ ANALYST PHILADELPHIA FINANCIAL: Hey Larry. Let me start off by really giving you a big compliment on -- not that you want it -- but on the revision or the reversal of the long-term incentive rewards. I mean in an environment where a lot of companies are paying themselves and every CEO [inaudible] or other ways to rape and pillage their shareholders off it's not what you want but it's a very shareholder-friendly action. My first question is at what dollar price does this become a break-even number? In other words if your share [inaudible] was 25 average in the quarter or 26 where does this number hit zero? CLAY SIMMONS: With -- I can take that Larry. In terms of not sustaining any vesting expense we are going to have vesting expense regardless because they 're -- not all of the shares that have been granted are fully vested. But the reference price is $25 a share. So to the extent that the stock price stays where it is today there would be a slight reduction of the vesting expense that we would expect over a quarter which is about $1.8 million. Does that answer the question? JORDAN HEIMOWITZ: Yes. Second question is on the -- what is the maximum leverage you are prepared to go to at this point? LARRY GOLDSTONE: Well I think that we are planning on trying to hold the line on leverage pretty much at the 8.5-ish 8.4% type of level. I don't think our plan -- well again as it relates to adjusted equity to adjusted assets which is the key operative metric for the company.

But I suspect that as we continue to do CDO financing transactions that's going to push up the overall leverage for the company and my sense is if we originate another $1.25 billion of loans in the fourth quarter you are going to see us do another $1.4 billion securitization in the fourth quarter and that will help to push up the overall leverage a little bit as well. I think ultimately we have talked about what GAAP equity of -- or core tangible equity of something in excess of 5% and I think we are at about 100 -- we are roughly 6% today. But that would be -- I mean that would be the absolute limit. JORDAN HEIMOWITZ: Okay. And final question is I thought Rick had a very good question that your marginal assets -- I mean who knows where your yield curve is going -- but your marginal assets are being put on at about 85-basis points and your total portfolio is about 102; is that correct? CLAY SIMMONS: A little less than 101. LARRY GOLDSTONE: So under 101. JORDAN HEIMOWITZ: Okay. So in effect that if the margin -- if the yield curve stays the way it is your marginal spread replaces your current spread in gaining prepayment or something like that and the earnings would drift lower ex the accumulative comprehensive income; correct? LARRY GOLDSTONE: No that is not correct. The net spread in the portfolio after prepayments is roughly 85-basis points. The new assets after prepayment activity are going on at 85-basis points so in fact the portfolio margin and the earnings would stay constant as it is. And to the extent that leverage increases or that we do additional fixed rate debt offerings like the preferred stock or unsecured debt transactions or additional CDO financing transactions we think you could see earnings growing modestly over time everything else held constant. JORDAN HEIMOWITZ: And that 85-basis points assumes no prepayments though because there will likely be some degree of prepayments although not as rapid as they have been. LARRY GOLDSTONE: No that assumes -- that is the net yield after prepayment amortization the 85-basis points. JORDAN HEIMOWITZ: Okay. I understand. LARRY GOLDSTONE: In other words we amortized in the third quarter 35-basis points of -- in order to get to the 446 -- was that the number? 446 yield on assets or 449? CLAY SIMMONS: Right. The weighted average coupon is 483 for the quarter. And then you would subtract from that premium amortization of 35-basis points and then there's an impact on our payment receivable and cash flow which amounts to 2-basis points additionally so that gets you to the 446. LARRY GOLDSTONE: Right. So the 85-basis points is after amortization of prepayments not before. So if there were a slowdown in prepayments you could see our spreads improve. JORDAN HEIMOWITZ: Okay. LARRY GOLDSTONE: And we actually expect that that's going to happen by the way in the fourth quarter and the first quarter of next year given the fact that we are moving out of the summer months which tend to be a seasonally high time period for prepayment activity and secondly because we have seen the 10-year treasury move up and all rates moving up with the 10-year being roughly 4.5% today versus 4% earlier in the third quarter. We are thinking that we could see some moderation in prepayment rates going forward. JORDAN HEIMOWITZ: And final question is next year what do you think is a normal provision that you are going to have? Obviously [inaudible] the credit has been so good. LARRY GOLDSTONE: What are we taking monthly Clay currently? CLAY SIMMONS: This quarter we took $375 000 on just the loan losses not including the non-accretable discount which will be on the whole pool purchases. But there's definitely tension between our external audit firm which looks at our historical losses and our reserve and really believes that we have too much loan loss reserves versus our models which would derive the 375. I think we're on with originations in the same level that we're at right now I think you could expect the 375 a quarter. JORDAN HEIMOWITZ: And what type of reserve level does that equate to? Your reserve isn't broken out on the balance sheet. CLAY SIMMONS: Well it is about 10 million on loans. LARRY GOLDSTONE: $13 billion. CLAY SIMMONS: It's about 8-basis points. LARRY GOLDSTONE: Right. About 8-basis points. JORDAN HEIMOWITZ: And is that where you think the losses will end up being on this about 8-basis points a year? LARRY GOLDSTONE: That's what our models suggest. JORDAN HEIMOWITZ: Okay. Thank you. OPERATOR: And the next question comes from the line of [Bruce Robinson] of Equity Pacific. Please go ahead. BRUCE ROBINSON ANALYST EQUITY PACIFIC: Good morning. I tell you what we are very pessimistic -- probably much more than you are -- about the prospects for the real estate markets. In that context what would you do or what would your outlook be if there was a precipitous industry-wide drop sort of a catastrophic drop-off in new mortgage origination activity? And what impact would that have frankly on the cash flows? LARRY GOLDSTONE: Well it wouldn't have -- we don't believe that it would have a significant impact on cash flows.

Number one if there were a decline in mortgage activity I assume that would imply a significant decline in refinance activity both cash-out refinances and rate-and-term refinances. And those continue to be 50% of total industry originations. So a lot of the work that we do or a lot of the origination activity that occurs is simply replacing assets that are paying off. And so I am assuming that in part you are thinking that originations are going to decline and that means that refinance and -- refinance activity is going to decline precipitously. Secondarily if the purchase money business declined that would be interesting as well. I don't know exactly what that would imply as far as our balance sheet growth goes. We haven't really looked at that number. It might imply if we can't grow our origination business we would just have to be more reliant on the purchase of either loans or mortgage-backed securities from others. The one thing you've got to keep in mind a significant percentage of mortgage originators are in the business of originating for sale to third parties and we happen to be one of those third parties that's an active buyer of mortgage product. So I don't have any concerns or not any significant concerns about our ability to acquire assets reinvest cash flow and continue to grow our balance sheet going forward. We are very very small player in a very very large market and even if the mortgage business were to be cut in half our market share would still be less than 1% of total originations in a year. BRUCE ROBINSON: Thank you. OPERATOR: And the next question comes from the line of Bob Napoli of Piper Jaffray. Please go ahead. BOB NAPOLI ANALYST PIPER JAFFRAY: Hi good morning or afternoon by now I guess. Couple of questions still left unanswered I guess Larry. And congratulations as well on your quarter especially relative to other consumer mortgage REITS. The interest rate outlook that you put forth in which you are comfortable with the dividend now historically you generally have -- when you 've talked about increases in interest rates -- talked about a move in the yield curve as opposed to just rising short end of the interest rates. Is that what you meant here if you had an inversion of the yield curve is that what you mean? Kind of a parallel shift in rates up the way you mentioned? LARRY GOLDSTONE: Actually no. All the scenarios we ran through our models implied more flattening. But just to be clear the shape of the yield curve has virtually nothing to do with our profitability. When we say we have a duration that's three or four months what that means is that we are lending and borrowing at the same point on the yield curve; we are not lending long and borrowing short or in the case of an inverted yield curve lending short and borrowing long to gain any profitability advantage. We are lending and borrowing at the same point on the yield curve. So the spread or the shape of the yield curve doesn't have a whole lot of direct impact on us. It has indirect impact based on shift in mortgage preference shift in product mix attractive -- relative attractiveness of short adjusting versus longer adjusting ARMs and those are different issues. So as it relates to those issues as the yield curve inverts or if the yield curve were to invert I guess I have two things to say about that. Number one we would just see a continued increase in consumer preference for longer dated mortgage products but it appears that our 5-1 7-1 and 10-1 products are being very favorably received and are very good consumer products and compete very nicely against 30-year and 15-year fixed rate mortgages . Now maybe that becomes a little bit more difficult if the curve really inverts out at the long end but the 10-1 product is just a better product for our customer than the 30-year fixed rate mortgage and we are seeing that being expressed in our origination volumes. I think secondly historically inverted yield curves are very unusual events.

They are typically indications of recessionary environments. They typically precede significant declines in short-term interest rates and I think that would -- I mean if we were to see the yield curve invert I think the next thing we are going to see is slowing economic activity and then I think reductions in the Fed funds rate and I think that's just going to be a huge win from an earnings perspective if that were to happen. BOB NAPOLI: Now Larry given the way you have locked in rates and they held up I mean your earnings have done much better. It's been a strategy that certainly others should consider. But when the Fed does eventually cut rates assuming we're going into a tougher economic environment essentially while you will benefit you probably won't benefit to the same extent as some others that have used essentially all short-term floating rate debt. I mean that is a fair statement? LARRY GOLDSTONE: That is absolutely true. BOB NAPOLI: And your business has transitioned. I mean historically going back years I first covered you guys you were more of a traditional ARM lender. Now over the years your portfolio has gotten longer and longer. You're almost becoming a fixed rate lender at this point. Now does that -- what does ma mean for your long-term return on equity? I mean you're more competing in some regards with Fanny and Freddy at this point are you not? LARRY GOLDSTONE: No I wouldn't say that. I guess a couple of comments relating to what you just said. Number one it is true that we have become more of a fixed-rate lender than an adjusted-rate lender to the extent that hybrid ARMs are more like fixed-rate products than they are floating-rate products; that is definitely true. However on a portfolio or from a portfolio duration perspective our portfolio duration today is actually shorter than it would have b

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