Edgar Filing: LUMINENT MORTGAGE CAPITAL INC

e10vq

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

(Mark One)

þ		Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
		for the quarterly period ended March 31, 2005


o		Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
		for the transition period from to

Commission File Number: 000-31828

LUMINENT MORTGAGE CAPITAL, INC.

(Exact name of registrant as specified in its charter)


Maryland (State or other jurisdiction of incorporation or		06-1694835 (I.R.S. Employer
organization)		Identification No.)

909 Montgomery Street, Suite 500, San Francisco, California		94133
(Address of principal executive offices)		(Zip Code)

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

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

Indicate by check mark whether 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 þ No o.

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes þ. No o.

The number of shares of our common stock outstanding on April 30, 2005 was 38,248,817.

INDEX


	PAGE
PART I

ITEM 1. FINANCIAL STATEMENTS		1
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS		22
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK		52
ITEM 4. CONTROLS AND PROCEDURES		56

PART II

ITEM 1. LEGAL PROCEEDINGS		56
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS		56
ITEM 3. DEFAULTS UPON SENIOR SECURITIES		56
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS		57
ITEM 5. OTHER INFORMATION		57
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K		57

SIGNATURES		58

EXHIBIT INDEX		59
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q contains certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are those that are not historical in nature. They can often be identified by the inclusion of words such as “will,” “anticipate,” “estimate,” “should,” “expect,” “believe,” “intend” and similar expressions. Any projection of revenues, earnings or losses, capital expenditures, distributions, capital structure or other financial terms is a forward-looking statement.

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

•	interest rate mismatches between our mortgage-backed securities and the borrowings we use to fund our purchases of such securities;

•	changes in interest rates and mortgage prepayment rates;

•	our ability to obtain or renew sufficient funding to maintain our leverage strategies;

•	potential impacts of our leveraging policies on our net income and cash available for distribution;

•	our limited operating history and the limited experience of Seneca Capital Management LLC, or Seneca, our management company, in managing a real estate investment trust, or REIT;

•	the ability of our board of directors to change our operating policies and strategies without stockholder approval or notice to you;

•	effects of interest rate caps on our adjustable-rate and hybrid adjustable-rate mortgage-backed securities;

•	the degree to which our hedging strategies may or may not protect us from interest rate volatility;

•	the fact that Seneca could be motivated to recommend riskier investments in an effort to maximize its incentive compensation under its management agreement with us;

•	potential conflicts of interest arising out of our relationship with Seneca, on the one hand, and Seneca’s relationships with other third parties, on the other hand;

•	our ability to invest up to 10% of our investment portfolio in lower-credit quality mortgage-backed securities that carry an increased likelihood of default or rating downgrade relative to investment-grade securities;

•	your inability to review the assets that we will acquire with the net proceeds of any securities we offer; and

•	the other important factors described in this Quarterly Report on Form 10-Q, including those under the captions “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Risk Factors” and “Quantitative and Qualitative Disclosures about Market Risk.”

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

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

PART I

FINANCIAL INFORMATION

Item 1. Financial Statements.

INDEX TO FINANCIAL STATEMENTS

Condensed Consolidated Financial Statements of Luminent Mortgage Capital, Inc.:


Condensed Consolidated Balance Sheets (unaudited) at March 31, 2005 and December 31, 2004			2

Condensed Consolidated Statements of Operations (unaudited) for the three months ended March 31, 2005 and March 31, 2004			3

Condensed Consolidated Statement of Stockholders’ Equity (unaudited) for the three months ended March 31, 2005			4

Condensed Consolidated Statements of Cash Flows (unaudited) for the three months ended March 31, 2005 and March 31, 2004			5

Notes to Condensed Consolidated Financial Statements (unaudited)			6

LUMINENT MORTGAGE CAPITAL, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)


	March 31,			December 31,
(in thousands, except share and per share amounts)	2005			2004
Assets:
Cash and cash equivalents	$	12,380		$	10,581
Mortgage-backed securities available-for-sale, at fair value		233,486			186,351
Mortgage-backed securities available-for-sale, pledged as collateral, at fair value		4,225,251			4,641,604
Interest receivable		17,705			18,861
Principal receivable		10,982			13,426
Futures contracts, at fair value		5,475			—
Swap contracts, at fair value		9,891			7,900
Other assets		1,640			1,105


Total assets	$	4,516,810		$	4,879,828


Liabilities:
Repurchase agreements	$	4,034,922		$	4,436,456
Junior subordinated notes		49,951			—
Cash distribution payable		13,770			15,959
Futures contracts, at fair value		—			1,073
Accrued interest expense		28,159			17,333
Management compensation payable, incentive compensation payable and other related party liabilities		1,143			2,952
Accounts payable and accrued expenses		985			552


Total liabilities		4,128,930			4,474,325


Stockholders’ Equity:
Preferred stock, par value $0.001:
10,000,000 shares authorized; no shares issued and outstanding		—			—
Common stock, par value $0.001:
100,000,000 shares authorized; 38,228,817 and 37,113,011 shares issued and outstanding at March 31, 2005 and December 31, 2004, respectively		38			37
Additional paid-in capital		490,637			478,457
Deferred compensation		(3,818	)		(2,207	)
Accumulated other comprehensive loss		(94,760	)		(61,368	)
Accumulated distributions in excess of accumulated earnings		(4,217	)		(9,416	)


Total stockholders’ equity		387,880			405,503


Total liabilities and stockholders’ equity	$	4,516,810		$	4,879,828

See notes to condensed consolidated financial statements

LUMINENT MORTGAGE CAPITAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)


	Three Months Ended March 31,
(in thousands, except share and per share amounts)	2005		2004
Revenues:
Net interest income:
Interest income	$	42,515	$	20,204
Interest expense		20,539		6,827


Net interest income		21,976		13,377

Expenses:
Management compensation expense to related party		1,098		787
Incentive compensation expense to related parties		470		846
Salaries and benefits		208		96
Professional services		562		417
Board of directors expense		119		56
Insurance expense		138		220
Custody expense		51		67
Other general and administrative expenses		361		88


Total expenses		3,007		2,577


Net income	$	18,969	$	10,800


Net income per share – basic	$	0.51	$	0.43


Net income per share – diluted	$	0.51	$	0.43


Weighted-average number of shares outstanding – basic		37,207,135		25,077,736


Weighted-average number of shares outstanding – diluted		37,376,107		25,085,784

See notes to condensed consolidated financial statements

LUMINENT MORTGAGE CAPITAL, INC.

CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY

(Unaudited)


													Accumulated
										Accumulate			Distributions
	Common Stock				Additional					Other			in Excess of
			Par		Paid-in		Deferred			Comprehensive			Accumulated			Comprehensive
(in thousands)	Shares		Value		Capital		Compensation			Income /(Loss)			Earnings			Income/(Loss)			Total
Balance, January 1, 2005		37,113	$	37	$	478,457	$	(2,207	)	$	(61,368	)	$	(9,416	)				$	405,503

Net income														18,969		$	18,969			18,969

Mortgage-backed securities available-for-sale, fair value adjustment											(36,490	)					(36,490	)		(36,490	)

Futures contracts, fair value adjustment											5,903						5,903			5,903

Futures contracts, net realized gains											(4,732	)					(4,732	)		(4,732	)

Swap contracts, fair value adjustment											1,927						1,927			1,927


Comprehensive loss																$	(14,423	)


Distributions to stockholders														(13,770	)					(13,770	)

Issuance of common stock		1,115		1		12,179		(1,611	)											10,569

Amortization of stock options						1														1


Balance, March 31, 2005		38,228	$	38	$	490,637	$	(3,818	)	$	(94,760	)	$	(4,217	)				$	387,880

See notes to condensed consolidated financial statements

LUMINENT MORTGAGE CAPITAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)


	Three Months Ended March 31,
(in thousands)	2005			2004
Cash flows from operating activities:
Net income	$	18,969		$	10,800
Adjustments to reconcile net income to net cash provided by operating activities:
Amortization of premium/discount on mortgage-backed securities available-for-sale		5,821			5,208
Amortization of stock options		1			2
Ineffectiveness (gains)/losses on cash flow hedges		(708	)		10
Changes in operating assets and liabilities:
(Increase)/decrease in interest receivable, net of purchased interest		1,156			(632	)
Increase in other assets		(2,146	)		(1,003	)
Increase/(decrease) in accounts payable and accrued expenses		488			(85	)
Increase in accrued interest expense		10,826			1,485
Increase in management fee payable, incentive compensation payable and other related party liabilities		440			1,474


Net cash provided by operating activities		34,847			17,259


Cash flows from investing activities:
Purchase of mortgage-backed securities available-for-sale		(6,183	)		(1,116,022	)
Principal payments of mortgage-backed securities		335,534			139,539


Net cash provided by (used in) investing activities		329,351			(976,483	)


Cash flows from financing activities:
Net proceeds from issuance of common stock		9,875			(356	)
Borrowings under repurchase agreements		3,429,257			11,141,921
Principal payments on repurchase agreements		(3,830,791	)		(10,175,120	)
Distributions to stockholders		(15,959	)		(5,267	)
Borrowing under junior subordinated notes, net of debt issuance costs		49,951			—
Amortization of net realized gains on Eurodollar futures contracts		(4,728	)		—
Realized losses on Eurodollar futures contracts		(4	)		(412	)
Other		—			(92	)


Net cash (used in) provided by financing activities		(362,399	)		960,674


Net increase in cash and cash equivalents		1,799			1,450
Cash and cash equivalents, beginning of the period		10,581			729


Cash and cash equivalents, end of the period	$	12,380		$	8,669


Supplemental disclosure of cash flow information:
Interest paid	$	15,848		$	5,328

Non-cash investing and financing activities:
Increase in unsettled security purchases	$	—		$	923,026
Increase in offering proceeds available		—			(157,865	)
(Increase)/decrease in principal receivable		2,444			(3,410	)
Incentive compensation payable settled through issuance of restricted stock		2,250			390
Accounts payable and accrued expenses settled through issuance of restricted stock		55			—
Deferred compensation reclassified to stockholders’ equity upon issuance of restricted stock		(1,611	)		(286	)

See notes to condensed consolidated financial statements

LUMINENT MORTGAGE CAPITAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 1—ACCOUNTING POLICIES

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

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

The information furnished in these unaudited consolidated condensed interim statements reflects all adjustments that are, in the opinion of management, necessary for a fair statement of the results for the periods presented. These adjustments are of a normal recurring nature, unless otherwise disclosed in this Form 10-Q. The results of operations in the interim statements do not necessarily indicate the results that may be expected for the full year. The interim financial information should be read in conjunction with the Company’s 2004 Annual Report on Form 10-K filed with the Securities and Exchange Commission, or SEC, on March 14, 2005 (file number 001-31828).

Descriptions of the significant accounting policies of the Company are included in Note 2 to financial statements in the Company’s 2004 Annual Report on Form 10-K. There have been no significant changes to these policies during 2005. See description of newly adopted and newly applicable accounting policies below.

Investment in Subsidiary Trust and Junior Subordinated Notes

On March 15, 2005, Diana Statutory Trust I, or the Trust, was created for the sole purpose of issuing and selling preferred securities. Diana Statutory Trust I is a special purpose entity. In accordance with Financial Accounting Standards Board Interpretation, or FIN, 46(R), Consolidation of Variable Interest Entities, the Trust is not consolidated into the Company’s consolidated financial statements, because the Company’s investment in the Trust is not considered to be a variable interest. The Company’s investment in the Trust is recorded in other assets on the balance sheet.

Junior subordinated notes issued to the Trust are accounted for as liabilities on the balance sheet net of deferred debt issuance costs. Interest expense on the notes and amortization of debt issue costs is recorded in the income statement.

See Note 7 for further discussion on the preferred securities of the Trust and junior subordinated notes.

Purchased Beneficial Interests

During the first quarter of 2005, the Company purchased certain beneficial interests in securitized financial assets required to be accounted for in accordance with Emerging Issues Task Force, or EITF, 99-20, Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets. Purchased beneficial interests are carried on the balance sheet at fair value and are included in mortgage-backed securities available-for-sale. In the event that a security becomes impaired, the cost of the security is written down and the difference is reflected in current earnings. Interest income is recognized using the effective yield method. The prospective method is used for adjusting the level yield used to recognize interest income when estimates of future cash flows over the remaining life of a security either increase or decrease. Cash flows are projected based on management’s assumptions for prepayment rates and credit losses. Actual economic conditions may produce cash flows that could differ significantly from projected cash flows, and could result in an increase or decrease in the yield used to record interest income or could result in an impairment charge.

LUMINENT MORTGAGE CAPITAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

Share-based Compensation

In December 2004, the Financial Accounting Standards Board, or FASB, issued SFAS No. 123(R) (revised 2004), Share-Based Payment. This Statement requires compensation expense to be recognized in an amount equal to the estimated fair value at the grant date of stock options and similar awards granted to employees. The accounting provisions of this Statement are effective for awards granted, modified or settled after July 1, 2005. The Company adopted this statement as of January 1, 2005, and has applied its provisions to awards granted to employees and directors. Adoption of SFAS No. 123(R) did not affect the accounting for restricted stock issued to the Manager, and did not have a material impact on the Company’s financial condition or results of operations.

NOTE 2—MORTGAGE-BACKED SECURITIES

The following table summarizes the Company’s mortgage-backed securities classified as available-for-sale at March 31, 2005, which are carried at fair value:


													Total
	Adjustable-			Hybrid			Balloon						Mortgage-
	Rate			Adjustable-Rate			Maturity			Other			Backed
(in thousands)	Securities			Securities			Securities			Securities			Securities
Amortized cost	$	116,273		$	4,387,928		$	55,008		$	5,316		$	4,564,525
Unrealized gains		25			—			—			299			324
Unrealized losses		(1,792	)		(102,482	)		(1,838	)		—			(106,112	)


Fair value	$	114,506		$	4,285,446		$	53,170		$	5,615		$	4,458,737


% of total		2.6	%		96.1	%		1.2	%		0.1	%		100.0	%

The Company’s portfolio of other mortgage-backed securities available-for-sale at March 31, 2005 included beneficial interests in securitized financial assets that the Company purchased from third parties.

The following table summarizes the Company’s mortgage-backed securities classified as available-for-sale at December 31, 2004, which are carried at fair value:


										Total
	Adjustable			Hybrid			Balloon			Mortgage-
	Rate			Adjustable-Rate			Maturity			Backed
(in thousands)	Securities			Securities			Securities			Securities
Amortized cost	$	127,360		$	4,714,759		$	55,134		$	4,897,253
Unrealized gains		33			739			—			772
Unrealized losses		(1,618	)		(67,340	)		(1,112	)		(70,070	)


Fair value	$	125,775		$	4,648,158		$	54,022		$	4,827,955


% of total		2.6	%		96.3	%		1.1	%		100.0	%

At March 31, 2005 and December 31, 2004, 62.1% and 61.4%, respectively, of the Company’s mortgage-backed securities portfolio, as measured by its fair value, was agency-guaranteed.

LUMINENT MORTGAGE CAPITAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

Actual maturities of mortgage-backed securities are generally shorter than stated contractual maturities. Actual maturities of the Company’s mortgage-backed securities are affected by the contractual lives of the underlying mortgages, periodic payments of principal and prepayments of principal. The following table summarizes the Company’s AAA-rated non-agency-backed and agency-backed mortgage-backed securities at March 31, 2005, according to their estimated weighted-average life classifications:


					Weighted-
					Average
Weighted-Average Life	Fair Value		Amortized Cost		Coupon
(in thousands)
Less than one year	$	600,010	$	610,882		3.58	%
Greater than one year and less than five years		3,853,112		3,948,327		4.31
Greater than five years		—		—		—


Total	$	4,453,122	$	4,559,209		4.21	%

The following table summarizes the Company’s mortgage-backed securities at December 31, 2004 according to their estimated weighted-average life classifications:


					Weighted-
					Average
Weighted-Average Life	Fair Value		Amortized Cost		Coupon
(in thousands)
Less than one year	$	211,475	$	215,099		3.76	%
Greater than one year and less than five years		4,616,480		4,682,154		4.24
Greater than five years		—		—		—


Total	$	4,827,955	$	4,897,253		4.22	%

The weighted-average lives of the mortgage-backed securities at March 31, 2005 and December 31, 2004 in the tables above are based upon data provided through subscription-based financial information services, assuming constant prepayment rates to the balloon or reset date for each security. The prepayment model considers current yield, forward yield, steepness of the yield curve, current mortgage rates, mortgage rate of the outstanding loan, loan age, margin and volatility.

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

LUMINENT MORTGAGE CAPITAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

The following table shows the fair value of the Company’s investments and the gross unrealized losses, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at March 31, 2005:


	Less than 12 Months					12 Months or More					Total
			Gross					Gross					Gross
	Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
(in thousands)	Value		Losses			Value		Losses			Value		Losses
Agency-backed mortgage-backed securities	$	1,188,135	$	(18,649	)	$	1,668,159	$	(42,481	)	$	2,856,294	$	(61,130	)

Non-agency-backed mortgage-backed securities		943,441		(25,618	)		649,430		(19,364	)		1,592,871		(44,982	)


Total temporarily impaired securities	$	2,131,576	$	(44,267	)	$	2,317,589	$	(61,845	)	$	4,449,165	$	(106,112	)


	Less than 12 Months					12 Months or More					Total
			Gross					Gross					Gross
	Fair		Unrealized					Unrealized			Fair		Unrealized
(in thousands)	Value		Losses			Fair Value		Losses			Value		Losses
Agency-backed mortgage-backed securities	$	2,473,670	$	(35,605	)	$	379,814	$	(5,701	)	$	2,853,484	$	(41,306	)

Non-agency-backed mortgage-backed securities		1,468,329		(22,189	)		251,452		(6,575	)		1,719,781		(28,764	)


Total temporarily impaired securities	$	3,941,999	$	(57,794	)	$	631,266	$	(12,276	)	$	4,573,265	$	(70,070	)

At March 31, 2005 and December 31, 2004, all of the Company’s portfolio that had unrealized losses was invested in AAA-rated non-agency-backed or agency-backed mortgage-backed securities. The temporary impairment of the available-for-sale securities results from the fair value of the securities falling below the amortized cost basis and is solely attributed to changes in interest rates. At March 31, 2005 and December 31, 2004, none of the securities held by the Company had been downgraded by a credit rating agency since their purchase. The Company intends and has the ability to hold the securities for a period of time, to maturity if necessary, sufficient to allow for the anticipated recovery in fair value of the securities held. As such, the Company does not believe any of the securities held at March 31, 2005 or December 31, 2004 are other-than-temporarily impaired.

LUMINENT MORTGAGE CAPITAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

NOTE 3—REPURCHASE AGREEMENTS AND OTHER BORROWINGS

The Company has entered into repurchase agreements with third party financial institutions to finance the purchase of most of its mortgage-backed securities. The repurchase agreements are short-term borrowings that bear interest rates that have historically moved in close relationship to the three-month London Interbank Offered Rate, or LIBOR. At March 31, 2005 and December 31, 2004, the Company had repurchase agreements with an outstanding balance of $4.0 billion and $4.4 billion, respectively, and with weighted-average interest rates of 2.66% and 2.38%, respectively. At March 31, 2005 and December 31, 2004, securities pledged as collateral for repurchase agreements had estimated fair values of $4.2 billion and $4.6 billion, respectively.

At March 31, 2005, the repurchase agreements had remaining maturities as summarized below:


	Overnight			Between			Between			Between
	(1 day or			2 and 30			31 and 90			91 and 512
(in thousands)	less)			days			days			days			Total
Agency-backed mortgage-backed securities:
Amortized cost of securities sold, including accrued interest	$	—		$	81,899		$	2,454,030		$	245,268		$	2,781,197
Fair market value of securities sold, including accrued interest		—			80,424			2,401,817			240,382			2,722,623
Repurchase agreement liabilities associated with these securities		—			76,179			2,284,746			227,568			2,588,493
Weighted-average interest rate of repurchase agreement liabilities		0.00	%		2.78	%		2.59	%		2.74	%		2.61	%
Non-agency-backed mortgage-backed securities:
Amortized cost of securities sold, including accrued interest	$	—		$	98,160		$	1,439,620		$	24,242		$	1,562,022
Fair market value of securities sold, including accrued interest		—			95,578			1,399,840			23,696			1,519,114
Repurchase agreement liabilities associated with these securities		—			90,533			1,333,464			22,432			1,446,429
Weighted-average interest rate of repurchase agreement liabilities		0.00	%		2.78	%		2.73	%		2.74	%		2.73	%
Total:
Amortized cost of securities sold, including accrued interest	$	—		$	180,059		$	3,893,650		$	269,510		$	4,343,219
Fair market value of securities sold, including accrued interest		—			176,002			3,801,657			264,078			4,241,737
Repurchase agreement liabilities associated with these securities		—			166,712			3,618,210			250,000			4,034,922
Weighted-average interest rate of repurchase agreement liabilities		0.00	%		2.78	%		2.64	%		2.74	%		2.66	%

LUMINENT MORTGAGE CAPITAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

At December 31, 2004, the repurchase agreements had remaining maturities as summarized below:


	Overnight			Between			Between			Between
	(1 day or			2 and 30			31 and 90			91 and 602
(in thousands)	less)			days			days			days			Total
Agency-backed mortgage-backed securities:
Amortized cost of securities sold, including accrued interest	$	20,203		$	153,656		$	1,017,753		$	1,702,727		$	2,894,339
Fair market value of securities sold, including accrued interest		20,010			152,100			1,005,208			1,677,425			2,854,743
Repurchase agreement liabilities associated with these securities		19,058			144,512			956,307			1,596,914			2,716,791
Weighted-average interest rate of repurchase agreement liabilities		2.36	%		2.28	%		2.41	%		2.35	%		2.37	%
Non-agency-backed mortgage-backed securities:
Amortized cost of securities sold, including accrued interest	$	17,795		$	53,278		$	998,982		$	763,429		$	1,833,484
Fair market value of securities sold, including accrued interest		17,555			52,706			982,301			752,376			1,804,938
Repurchase agreement liabilities associated with these securities		16,719			50,132			936,901			715,913			1,719,665
Weighted-average interest rate of repurchase agreement liabilities		2.36	%		2.27	%		2.44	%		2.35	%		2.35	%
Total:
Amortized cost of securities sold, including accrued interest	$	37,998		$	206,934		$	2,016,735		$	2,466,156		$	4,727,823
Fair market value of securities sold, including accrued interest		37,565			204,806			1,987,509			2,429,801			4,659,681
Repurchase agreement liabilities associated with these securities		35,777			194,644			1,893,208			2,312,827			4,436,456
Weighted-average interest rate of repurchase agreement liabilities		2.36	%		2.28	%		2.43	%		2.35	%		2.38	%

LUMINENT MORTGAGE CAPITAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

At March 31, 2005, the repurchase agreements had the following counterparties, amounts at risk and weighted-average remaining maturities:


			Weighted-Average
			Maturity of
	Amount at		Repurchase
Repurchase Agreement Counterparties	Risk⁽¹⁾		Agreements
	(in thousands)		(in days)
Banc of America Securities LLC	$	8,856		63
Bear Stearns & Co.		49,598		57
Countrywide Securities Corporation		2,008		43
Deutsche Bank Securities Inc.		45,586		63
Goldman Sachs & Co.		14,600		63
Lehman Brothers Inc.		4,209		61
Merrill Lynch Government Securities Inc./Merrill Lynch Pierce, Fenner & Smith Inc.		6,982		68
Morgan Stanley & Co. Inc.		1,422		66
Nomura Securities International, Inc.		8,370		67
Salomon Smith Barney		6,051		68
UBS Securities LLC		27,088		248
Wachovia Securities, LLC		4,061		64


Total	$	178,831		90

(1)

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

At December 31, 2004, the repurchase agreements had the following counterparties, amounts at risk and weighted-average remaining maturities:


			Weighted-Average
			Maturity of
	Amount at		Repurchase
Repurchase Agreement Counterparties	Risk⁽¹⁾		Agreements
	(in thousands)		(in days)
Banc of America Securities LLC	$	11,970		61
Bear Stearns & Co.		60,106		100
Countrywide Securities Corporation		4,534		115
Deutsche Bank Securities Inc.		42,589		142
Goldman Sachs & Co.		23,489		51
Lehman Brothers, Inc.		4,244		151
Merrill Lynch Government Securities Inc./Merrill Lynch Pierce, Fenner & Smith Inc.		8,509		125
Morgan Stanley & Co. Inc.		2,039		124
Nomura Securities International, Inc.		9,355		114
Salomon Smith Barney		12,151		69
UBS Securities LLC		23,413		314
Wachovia Securities, LLC		3,493		154


Total	$	205,892		133

(1)

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

The Company has a margin lending facility with its primary custodian whereby it may borrow money in connection with the purchase or sale of securities. The terms of the borrowings, including the rate of interest payable, will be agreed to with the custodian for each amount borrowed. Borrowings are repayable upon demand by

LUMINENT MORTGAGE CAPITAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

the custodian. No borrowings were outstanding under the margin lending facility at March 31, 2005 or December 31, 2004.

NOTE 4—CAPITAL STOCK AND NET INCOME PER SHARE

At March 31, 2005 and December 31, 2004, the Company’s charter authorized the issuance of 100,000,000 shares of common stock, par value $0.001 per share, and 10,000,000 shares of preferred stock, par value $0.001 per share. At March 31, 2005 and December 31, 2004, 38,228,817 and 37,113,011 shares of common stock, respectively, were outstanding and no shares of preferred shares were outstanding.

In June 2004, the Company reserved 10,000,000 shares of common stock for issuance in connection with the payment of incentive compensation under the Company’s Management Agreement with the Manager. At March 31, 2005 and December 31, 2004, 9,641,649 shares and 9,726,111 shares, respectively, remained reserved for this purpose. On March 26, 2005, effective as of March 1, 2005, the Company and the Manager entered into an Amended and Restated Management Agreement. Under the Amended and Restated Management Agreement, none of the incentive compensation payable to the Manager will be payable in the Company’s common stock.

On January 3, 2005, the Company filed a shelf registration statement on Form S-3 with the SEC. This registration statement was declared effective by the SEC on January 21, 2005. Under the shelf registration statement, the Company may offer and sell any combination of common stock, preferred stock, warrants to purchase common stock or preferred stock and debt securities in one or more offerings up to total proceeds of $500.0 million. Each time the Company offers to sell securities, a supplement to the prospectus will be provided containing specific information about the terms of that offering. At March 31, 2005, total proceeds of up to $490.0 million remain available to the Company to offer and sell under this shelf registration statement.

On February 7, 2005, the Company entered into a Controlled Equity Offering Sales Agreement with Cantor Fitzgerald & Co., or Cantor Fitzgerald, through which the Company may sell common stock or preferred stock from time to time through Cantor Fitzgerald acting as agent and/or principal in privately negotiated and/or at-the-market transactions. During the three months ended March 31, 2005, the Company sold approximately 1.0 million shares of common stock pursuant to this agreement and the Company received proceeds, net of commissions and other offering costs, of approximately $10.0 million.

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

LUMINENT MORTGAGE CAPITAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

The following table presents a reconciliation of basic and diluted net income per share for the three months ended March 31, 2005 and 2004:


	Three Months Ended March 31,
	2005				2004
	Basic		Diluted		Basic		Diluted
Net income (in thousands)	$	18,969	$	18,969	$	10,800	$	10,800

Weighted-average number of common shares outstanding		37,207,135		37,207,135		25,077,736		25,077,736
Additional shares due to assumed conversion of dilutive instruments		—		168,972		—		8,048

Adjusted weighted-average number of common shares outstanding		37,207,135		37,376,107		25,077,736		25,085,784


Net income per share	$	0.51	$	0.51	$	0.43	$	0.43

NOTE 5—2003 STOCK INCENTIVE PLANS

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

The following table illustrates the common stock available for grant at March 31, 2005:


			2003 Outside
	2003 Stock		Advisors Stock
	Incentive Plan		Incentive Plan		Total
Shares reserved for issuance						1,000,000	⁽¹⁾
Granted		214,666		—		214,666
Forfeited		—		—		—
Expired		—		—		—

Total available for grant						785,334	⁽²⁾

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

(2)		At March 31, 2005, the maximum number of shares of common stock that may be issued pursuant to awards granted under these combined plans is 785,334 shares.

LUMINENT MORTGAGE CAPITAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

At March 31, 2005, the Company had outstanding options under the plans with expiration dates of 2013. The following table summarizes all stock option transactions during the three months ended March 31, 2005:


			Weighted-
	Number of		Average
	Options		Exercise Price
Outstanding, beginning of period		55,000	$	14.82
Granted		—		—
Exercised		—		—
Forfeited		—		—

Outstanding, end of period		55,000	$	14.82

The following table summarizes certain information about stock options outstanding at March 31, 2005:


	Outstanding						Exercisable
			Weighted-
			Average		Weighted-				Weighted-
	Number		Remaining		Average		Number		Average
Range of	of		Life (in		Exercise		of		Exercise
Exercise Prices	Options		years)		Price		Options		Price
$13.00-$14.00		5,000		8.6	$	13.00		1,667	$	13.00
$14.01-$15.00		50,000		8.3		15.00		16,667		15.00

$13.00-$15.00		55,000			$	14.82		18,334	$	14.82

The following table illustrates the changes in nonvested stock options during the three months ended March 31, 2005:


			Weighted-
			Average
	Number of		Grant-Date
	Options		Fair Value
Nonvested, beginning of the period		36,666	$	0.22
Granted		—		—
Vested		—		—
Forfeited		—		—

Nonvested, end of the period		36,666	$	0.22

Total stock-based employee compensation expense related to stock option awards for the three months ended March 31, 2005 and 2004 was $1 thousand and $2 thousand, respectively. At March 31, 2005, stock-based employee compensation expense of $2 thousand related to nonvested stock options is expected to be recognized over a weighted-average period of 1.3 years.

LUMINENT MORTGAGE CAPITAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

The following table illustrates the changes in common stock awards during the three months ended March 31, 2005:


			Weighted-
	Number of		Average Issue
	Common Shares		Price
Outstanding, beginning of period		25,122	$	12.06
Issued		129,707		11.38
Repurchased		—		—

Outstanding, end of period		154,829	$	11.49

The following table illustrates the changes in nonvested common stock awards during the three months ended March 31, 2005:


				Weighted-
				Average
	Number of			Grant-Date
	Common Shares			Fair Value
Nonvested, beginning of the period		25,122		$	12.06
Granted		129,707			11.38
Vested		(499	)		14.41
Repurchased		—			—

Nonvested, end of the period		154,330		$	11.48

Total stock-based employee compensation expense related to common stock awards for the three months ended March 31, 2005 and 2004 was $21 thousand and $9 thousand, respectively. At March 31, 2005, stock-based employee compensation expense of $1.7 million related to nonvested common stock awards is expected to be recognized over a weighted-average period of 2.3 years.

NOTE 6—THE MANAGEMENT AGREEMENT

The Company entered into an Amended and Restated Management Agreement, dated as of March 1, 2005, or New Management Agreement, with the Manager that provides, among other things, that the Company will pay to the Manager, in exchange for investment management and certain administrative services, certain fees and reimbursements, summarized as follows:

	•	base management compensation equal to a percentage of applicable average net worth, as defined in the New Management Agreement, paid quarterly in arrears, calculated at the following rates per annum: (1) 0.90% of the first $750 million; plus (2) 0.70% of the next $750 million; plus (3) 0.50% of the amount in excess of $1.5 billion;

	•	incentive management compensation equal to a percentage of applicable average net worth, as defined in the New Management Agreement, paid annually, calculated at the following rates per annum: (1) 0.35% for the first $750 million of applicable average net worth; (2) 0.20% for the next $750 million of applicable average net worth; and (3) 0.15% for the applicable average net worth in excess of $1.5 billion) if the return on assets, as defined in the New Management Agreement, for any such fiscal year exceeds the threshold return, defined as the average of the weekly values for any period of the sum of (i) the 10-year U.S. Treasury rate for such period and (ii) two percent (2%); and

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

LUMINENT MORTGAGE CAPITAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

Under the New Management Agreement, the base management compensation and incentive management compensation are paid to the Manager by the Company in cash.

The Company is entitled to terminate the New Management Agreement without cause provided that the Company gives the Manager at least 60 days’ prior written notice and pays a termination fee and other unpaid costs and expenses reimbursable to the Manager. If the Company terminates the New Management Agreement without cause, the Company is required to pay the Manager a termination fee equal to two times the amount of the highest annual base management compensation and the highest annual incentive management compensation, for a particular year, earned by the Manager during any of the three years (or on an annualized basis if a lesser period) preceding the effective date of the termination, multiplied by a fraction, where the numerator is the positive difference (if any) resulting from thirty-six (36) minus the number of months (rounded to the nearest whole month) between the effective date of the New Management Agreement and the termination date, and the denominator is thirty-six (36).

The Company is also entitled to terminate the New Management Agreement for cause, in which case the Company is only obligated to reimburse unpaid costs and expenses. In addition, the Manager will forfeit any then-unvested stock of the Company pursuant to the terms of the restricted stock award agreements issued at the time of the stock grants.

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

The base management compensation for the three months ended March 31, 2005 was $1.1 million. No incentive compensation was earned by the Manager for the three months ended March 31, 2005. The incentive compensation expense of $470 thousand for the three months ended March 31, 2005 relates to restricted common stock awards granted for incentive compensation earned in prior periods that vested during the period.

Prior to the Amended and Restated Management Agreement, the Company had entered into a Management Agreement, dated as of June 11, 2003, or Prior Management Agreement. Under the Prior Management Agreement, the Company was required to pay the Manager, in exchange for investment management and certain administrative services, certain fees and reimbursements, summarized as follows:

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

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

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

LUMINENT MORTGAGE CAPITAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

Under the Prior Management Agreement, the base management compensation and incentive compensation was paid quarterly and was subject to adjustment at the end of each fiscal year based on annual results. One-half of the incentive compensation was paid to the Manager in cash and one-half was paid in the form of a restricted stock award. The number of shares issued was based on (a) one-half of the total incentive compensation for the period, divided by (b) the average of the closing prices of the common stock over the 30-day period ending three calendar days prior to the grant date, less a fair market value discount determined by the Company’s Board of Directors. These shares are “restricted shares” for varying periods of time, and are forfeitable if the Manager ceases to perform management services for the Company before the end of the restriction periods. The restrictions lapse and full rights of ownership vest for one-third of the shares on the first anniversary of the end of the period in which the incentive compensation is calculated, for one-third of the shares on the second anniversary and for the last one-third of the shares on the third anniversary. Vesting is predicated on the continuing involvement of the Manager in providing services to the Company. In accordance with SFAS No. 123, and related interpretations, and EITF 96-18, 15.2% of the restricted stock portion of the incentive compensation was expensed in the period incurred.

The base management compensation for the three months ended March 31, 2004 was $787 thousand.

Under the Prior Management Agreement, incentive compensation was earned by the Manager when REIT taxable net income (before deducting incentive compensation, net operating losses and certain other items) relative to the net invested assets for the period, defined in the Prior Management Agreement, exceeds the “threshold return” taxable income that would produce an annualized return on equity equal to the sum of the 10-year U.S. Treasury rate plus 2% for the same period. For the three months ended March 31, 2004, REIT taxable income (before deducting incentive compensation, net operating losses and certain other items) was $11.2 million and was greater than the “threshold return” taxable income of $4.7 million.

For the three months ended March 31, 2004, total incentive compensation earned by the Manager was $1.3 million, one-half payable in cash and one-half payable in the form of the Company’s restricted common stock. The cash portion of the incentive compensation of $652 thousand for the three months ended March 31, 2004 was expensed in that period as well as 15.2% of the restricted common stock portion of the incentive compensation, or $99 thousand.

In accordance with the terms of his employment agreement, the Company’s chief financial officer is eligible to earn incentive compensation. No incentive compensation was earned for the three months ended March 31, 2005. The chief financial officer earned incentive compensation of $65 thousand for the three months ended March 31, 2004. This incentive compensation was also payable one-half in cash and one-half in the form of a restricted common stock award under the Company’s 2003 Stock Incentive Plan. The shares vest over the same vesting schedule as the stock issued to the Manager. The cash portion of the incentive compensation of $33 thousand for the three months ended March 31, 2004 was expensed in the period incurred. In addition, $5 thousand related to the restricted common stock portion of the incentive compensation for the three months ended March 31, 2004 was expensed.

The remaining incentive compensation expense of $57 thousand for the three months ended March 31, 2004 relates primarily to restricted common stock awards vested during the period.

NOTE 7—RELATED PARTY TRANSACTIONS

At March 31, 2005 and December 31, 2004, the Company was indebted to the Manager for base management fees of $1.1 million. At March 31, 2005, the Company was not indebted to the Manager for any incentive compensation and at December 31, 2004, the Company was indebted to the Manager for incentive compensation of $1.6 million. The Company was not indebted to the Manager for reimbursement of expenses at March 31, 2005 and was indebted to the Manager for reimbursement of expense of $3 thousand at December 31, 2004. At March 31, 2005, the Company was not indebted to the Company’s chief financial officer for incentive

LUMINENT MORTGAGE CAPITAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

compensation and at December 31, 2004, the Company was indebted to the Company’s chief financial officer for incentive compensation of $167 thousand. The Company was indebted to the officers and employees of the Company for bonuses and expense reimbursement of $45 thousand and $10 thousand at March 31, 2005 and December 31, 2004, respectively. These amounts are included in management fee payable, incentive compensation payable and other related party liabilities.

The Manager’s financial relationship with the Company was governed by the Prior Management Agreement and is now governed by the New Management Agreement. Under the New Management Agreement, the Manager shall be responsible for all expenses of the personnel employed by the Manager, and all facilities and overhead expenses of the Manager required for the day-to-day operations of the Company, and the expenses of a sub-manager, if any. The Company shall reimburse the Manager for its pro-rata portion of facilities and overhead expenses to the extent that the Company’s employees (who are not also employed by the Manager) use such facilities or incur such expenses pursuant to a cost-sharing agreement entered into between the Company and the Manager. At March 31, 2005, $3 thousand was payable to the Manager pursuant to the cost-sharing agreement. At December 31, 2004, no expenses were payable to the Manager pursuant to the cost-sharing agreement. During the three months ended March 31, 2005 and 2004, the Company paid the Manager $7 thousand and $6 thousand pursuant to the cost-sharing agreement, respectively. The Company shall pay all other expenses on behalf of the Company, and shall reimburse the Manager for all direct expenses incurred on the Company’s behalf that are not the Manager’s specific responsibility as defined in the New Management Agreement.

NOTE 8—FAIR VALUE OF FINANCIAL INSTRUMENTS

SFAS No. 107, Disclosure About Fair Value of Financial Instruments, requires disclosure of the fair value of financial instruments for which it is practicable to estimate that value. The fair value of mortgage-backed securities available-for-sale, futures contracts and interest rate contracts is equal to their carrying value presented in the balance sheet. The fair value of cash and cash equivalents, interest receivable, principal receivable, repurchase agreements, unsettled security purchases and accrued interest expense approximates cost at March 31, 2005 and December 31, 2004 due to the short-term nature of these instruments. The carrying value and fair value of the Company’s junior subordinated notes was $51.6 million and $51.1 million, respectively, at March 31, 2005.

NOTE 9—ACCUMULATED OTHER COMPREHENSIVE LOSS

The following is a summary of the components of accumulated other comprehensive loss at March 31, 2005 and December 31, 2004:


	March 31,			December 31,
(in thousands)	2005			2004
Net unrealized losses on mortgage-backed securities available-for-sale	$	(105,788	)	$	(69,297	)
Net deferred realized and unrealized gains on cash flow hedges		11,028			7,929

Accumulated other comprehensive loss	$	(94,760	)	$	(61,368	)

NOTE 10—DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES

The Company seeks to manage its interest rate risk exposure and protect the Company’s repurchase agreement liabilities against the effects of major interest rate changes. Such interest rate risk may arise from the issuance and forecasted rollover and repricing of short-term liabilities with fixed rate cash flows or from liabilities with a contractual variable rate based on LIBOR. Among other strategies, the Company may use Eurodollar futures contracts and interest rate swaps to manage this interest rate risk. Derivative instruments are carried at fair value.

LUMINENT MORTGAGE CAPITAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

The following table is a summary of derivative instruments held at March 31, 2005:


	Unrealized		Unrealized	Estimated
(in thousands)	Gains		Losses	Fair Value
Eurodollar futures contracts sold short	$	5,475	—	$	5,475
Interest rate swap contracts		9,891	—		9,891

Total derivative instruments	$	15,366	—	$	15,366

The following table is a summary of derivative instruments held at December 31, 2004:


	Unrealized		Unrealized			Estimated
(in thousands)	Gains		Losses			Fair Value
Eurodollar futures contracts sold short	$	368	$	(1,441	)	$	(1,073	)
Interest rate swap contracts		7,900		—			7,900

Total derivative instruments	$	8,268	$	(1,441	)	$	6,827

Cash Flow Hedging Strategies

Hedging instruments are designated as cash flow hedges, as appropriate, based upon the specifically identified exposure. The hedged transaction is the forecasted interest expense on forecasted rollover/reissuance of repurchase agreements or the interest rate repricing of repurchase agreements for a specified future time period. The hedged risk is the variability in those payments due to changes in the benchmark rate. Hedging transactions are structured at inception so that the notional amounts of the hedge are matched with an equal amount of repurchase agreements forecasted to be outstanding in that specified period for which the borrowing rate is not yet fixed. Cash flow hedging strategies include the utilization of Eurodollar futures contracts and interest rate swap contracts. Hedging instruments under these strategies are deemed to be broadly designated to the outstanding repurchase portfolio and the forecasted rollover thereof. Such forecasted rollovers would also include other types of borrowing arrangements that may replace the repurchase funding during the identified hedge time periods. At March 31, 2005 and December 31, 2004, the maximum length of time over which the Company is hedging its exposure was 12 months and 15 months, respectively.

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

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

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

LUMINENT MORTGAGE CAPITAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

The hedge instrument must be highly effective in achieving offsetting changes in the hedged item attributable to the risk being hedged in order to qualify for hedge accounting. In order to determine whether the hedge instrument is highly effective, the Company uses regression methodology to assess the effectiveness of its hedging strategies. Specifically, at the inception of each new hedge and on an ongoing basis, the Company assesses effectiveness using “ordinary least squares” regression to evaluate the correlation between the rates consistent with the hedge instrument and the underlying hedged items. A hedge instrument is highly effective if the changes in the fair value of the derivative provide offset of at least 80% and not more than 125% of the changes in fair value or cash flows of the hedged item attributable to the risk being hedged. The futures and interest rate swap contracts are carried on the balance sheet at fair value. Any ineffectiveness that arises during the hedging relationship is recognized in interest expense during the period in which it arises.

During the three months ended March 31, 2005 and 2004, gains of $592 thousand and losses of $14 thousand, respectively, were recognized in interest expense due to hedge ineffectiveness. During the three months ended March 31, 2005, interest expense was decreased by $4.7 million of amortization of net realized gains on Eurodollar futures contracts and $819 thousand of net interest income received from swap contract counterparties. Based upon the combined amounts of $3.3 million of net deferred realized losses and $4.7 million of net unrealized gains from Eurodollar futures contracts included in accumulated other comprehensive income and loss at March 31, 2005, the Company expects to recognize lower interest expense during the remainder of 2005 and part of 2006. This amount could differ from amounts actually realized due to changes in the benchmark rate between March 31, 2005 and when the Eurodollar futures contracts sold short at March 31, 2005 are covered, as well as the addition of other hedges subsequent to March 31, 2005.

NOTE 11—PREFERRED SECURITIES OF SUBSIDIARY TRUST AND JUNIOR SUBORDINATED NOTES

On March 15, 2005, the Trust issued 50,000 Floating Rate Preferred Securities, or Preferred Securities, for gross proceeds of $50.0 million. The combined proceeds from the issuance of the Preferred Securities and the issuance to the Company of the Common Securities of the Trust were invested by the Trust in $51.6 million aggregate principal amount of Junior Subordinated Notes issued by the Company. The Junior Subordinated Notes are the sole assets of the Trust and are due March 31, 2035 and bear interest at the fixed rate of 8.16% per annum commencing on March 15, 2005 through March 30, 2010. Thereafter, the Junior Subordinated Notes bear interest at a variable rate equal to three-month LIBOR plus 3.75% per annum through maturity. Interest is payable quarterly.

The Junior Subordinated Notes are redeemable on any interest payment date at the option of the Company in whole, but not in part, on or after March 30, 2010 at the redemption rate of 100% plus accrued and unpaid interest. Prior to March 30, 2010, upon the occurrence of a special event relating to certain federal income tax matters, the Company may redeem the Junior Subordinated Notes in whole, but not in part, at the redemption rate of 107.5% plus accrued and unpaid interest.

The holders of the Preferred Securities and the Common Securities, or Trust Securities, are entitled to receive distributions at the fixed rate of 8.16% per annum of the stated liquidation amount of $1,000 per security commencing on March 15, 2005 through March 30, 2010. Thereafter, the Trust Securities are entitled to receive distributions at a variable rate equal to three-month LIBOR plus 3.75% per annum of the stated liquidation amount of $1,000 per security through maturity. Distributions are payable quarterly. The Trust Securities do not have a stated maturity date; however, they are subject to mandatory redemption upon the maturity of the Junior Subordinated Notes.

Unamortized deferred issuance costs associated with the Junior Subordinated Notes amounted to $1.6 million at March 31, 2005 and are being amortized using the effective yield method over the term of the Junior Subordinated Notes.

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

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

General

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

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

	•	interest rate mismatches between our mortgage-backed securities and the borrowings we use to fund our purchases of such securities;

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

	•	the potential for increased borrowing costs related to repurchase agreements;

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

	•	the overall leverage of our portfolio;

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

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

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

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

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

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

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

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

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

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

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

Critical Accounting Policies

Our financial statements are prepared in accordance with GAAP. These accounting principles require us to make some complex and subjective decisions and assessments. Our most critical accounting policies involve decisions and assessments that could significantly affect our reported assets and liabilities, as well as our reported revenues and expenses. We believe that all of the decisions and assessments upon which our financial statements are based were reasonable at the time made based upon information available to us at that time. See Note 2 to our financial statements included in Item 8 of our 2004 Annual Report on Form 10-K for a complete discussion of our significant accounting policies. Management has identified our most critical accounting policies to be the following:

Classifications of Investment Securities

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

Valuations of Mortgage-backed Securities

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

When the fair value of an available-for-sale security is less than amortized cost, management considers whether there is an other-than-temporary impairment in the value of the security. If, in management’s judgment, an other-than-temporary impairment exists, the cost basis of the security is written down to the then-current fair value,

and the unrealized loss is transferred from accumulated other comprehensive loss as an immediate reduction of current earnings (as if the loss had been realized in the period of impairment). The determination of other-than-temporary impairment is a subjective process, and different judgments and assumptions could affect the timing of loss realization.

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

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

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

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

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

Interest Income Recognition

Interest income on our mortgage-backed securities is accrued based on the actual coupon rate and the outstanding principal amount of the underlying mortgages. Premiums and discounts are amortized or accreted into interest income over the lives of the securities using the effective yield method adjusted for the effects of estimated prepayments based on Statement of Financial Accounting Standards, or SFAS, No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases. If our estimate of prepayments is incorrect, we may be required to make an adjustment to the amortization or accretion of premiums and discounts that would have an impact on future income. Purchased beneficial interests in securitized financial assets are accounted for in accordance with Emerging Issues Task Force, or EITF, 99-20, Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets. Interest income is recognized using the effective yield method. The prospective method is used for adjusting the level yield used to recognize interest income when estimates of future cash flows over the remaining life of the security either increase or decrease. Cash flows are projected based on management’s assumptions for prepayment rates and credit losses. Actual economic conditions may produce cash flows that could differ significantly from projected cash flows, and differences could result in an increase or decrease in the yield used to record interest income or could result in an impairment charge.

Accounting for Derivative Financial Instruments and Hedging Activities

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

At March 31, 2005, we have engaged in short sales of Eurodollar futures contracts to mitigate our interest rate risk for the specified future time period, which is defined as the calendar quarter immediately following the contract expiration date. The value of these futures contracts is marked-to-market daily in our margin account with the custodian. Based upon the daily market value of these futures contracts, we either receive funds into, or wire funds into, our margin account with the custodian to ensure that an appropriate margin account balance is maintained at all times through the expiration of the contracts.

At March 31, 2005, we have entered into interest rate swap contracts to mitigate our interest rate risk for the period defined by the maturity of the swap. Cash flows that occur each time the swap is repriced are associated with forecasted interest expense for a specified future period, which is defined as the calendar period preceding each repricing date with the same number of months as the repricing frequency.

The futures and interest rate swap contracts, or hedge instruments, have been designated as cash flow hedges and are evaluated at inception and on an ongoing basis in order to determine whether they qualify for hedge accounting under SFAS No. 133, as amended and interpreted. The hedge instrument must be highly effective in achieving offsetting changes in the hedged item attributable to the risk being hedged in order to qualify for hedge accounting. In order to determine whether the hedge instrument is highly effective, we use regression methodology to assess the effectiveness of our hedging strategies. Specifically, at the inception of each new hedge and on an ongoing basis, we assess effectiveness using “ordinary least squares” regression to evaluate the correlation between the rates consistent with the hedge instrument and the underlying hedged items. A hedge instrument is highly effective if the changes in the fair value of the derivative provide offset of at least 80% and not more than 125% of the changes in fair value or cash flows of the hedged item attributable to the risk being hedged. The futures and interest rate swap contracts are carried on the balance sheet at fair value. Any ineffectiveness which arises during the hedging relationship, is recognized in interest expense during the period in which it arises. Prior to the end of the specified hedge time period the effective portion of all contract gains and losses (whether realized or unrealized) is recorded in other comprehensive income or loss. Realized gains and losses on futures contracts are reclassified into earnings as an adjustment to interest expense during the specified hedge time period. Realized gains and losses on interest rate swap contracts are reclassified into earnings as an adjustment to interest expense during the period subsequent to the swap repricing date through the remaining maturity of the swap. For REIT taxable net income purposes, realized gains and losses on futures and interest rate swap contracts are reclassified into earnings immediately when positions are closed or have expired.

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

Management Incentive Compensation Expense

On March 26, 2005, we entered into an Amended and Restated Management Agreement, or New Management Agreement, as of March 1, 2005, with Seneca which supercedes the Management Agreement, as of June 11, 2003, or Prior Management Agreement. The New Management Agreement provides for the payment of incentive compensation to Seneca if our financial performance exceeds certain benchmarks. During each quarter of the fiscal year, we will calculate the incentive compensation expense on a cumulative basis, making any necessary adjustments for amounts that were recognized in previous quarters. As a result, if we experience poor quarterly performance in a particular quarter and this causes the cumulative incentive compensation expense for the current quarter to be lower than the cumulative incentive compensation for the prior quarter, we will record a negative incentive compensation expense in the current quarter. The incentive compensation is payable annually in cash and is accrued and expensed during the period for which it is calculated.

Under the Prior Management Agreement, incentive compensation was paid one-half in the form or our restricted common stock. We account for the restricted stock portion of the incentive compensation in accordance with SFAS No. 123, Accounting for Stock-based Compensation, and related interpretations, and EITF 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.

Under the Prior Management Agreement, each incentive compensation restricted stock grant to Seneca is divided into three tranches. The first tranche will vest over a one-year period and be expensed over approximately five quarters, beginning in the quarter in which it was earned. The second tranche will vest over a two-year period and be expensed over approximately nine quarters beginning in the quarter in which it was earned. The third tranche will vest over a three-year period and be expensed over approximately 13 quarters beginning in the quarter in which it was earned. Upon vesting of each tranche, an adjustment is made to account for the vested tranche at fair value. As a result of this vesting schedule for the restricted stock granted to Seneca, we will incur incentive compensation expense in each of the periods following the grant of the restricted stock over a three-year period. We will continue

to incur incentive compensation expense related to each restricted stock grant, even in subsequent periods in which Seneca did not earn incentive compensation.

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

Under the Prior Management Agreement, Seneca was granted multiple tranches of restricted common stock for incentive compensation. Management compensation expense will increase or decrease due to the vesting schedules and the mark-to-market impact of the unvested portions of the restricted stock grants, even in periods where there is little change in our income or stock price.

We also pay incentive compensation to our chief financial officer, in accordance with the terms of his employment agreement. The incentive compensation is accounted for in the same manner as the incentive compensation earned by Seneca; however, at the measurement date of the incentive compensation earned for a given fiscal year, an adjustment is made to the cumulative awards and they are recorded at the final grant date fair value in accordance with SFAS No. 123(R).

Recent Accounting Pronouncements

In December 2004, the Financial Accounting Standards Board, or FASB, issued SFAS No. 123(R) (revised 2004), Share-Based Payment. This Statement requires compensation expense to be recognized in an amount equal to the estimated fair value at the grant date of stock options and similar awards granted to employees. The accounting provisions of this Statement are effective for awards granted, modified or settled after July 1, 2005. We adopted this statement as of January 1, 2005, and has applied its provisions to awards granted to employees and directors. Adoption of SFAS No. 123(R) did not affect the accounting for restricted stock issued to Seneca, and did not have a material impact on our financial condition or results of operations.

Financial Condition

All of our assets at March 31, 2005 were acquired with the proceeds from our private placement and public offerings of our common stock and the use of leverage. On February 7, 2005, we entered into a Controlled Equity Offering Sales Agreement with Cantor Fitzgerald & Co., or Cantor Fitzgerald, through which we may sell common stock or preferred stock from time to time through Cantor Fitzgerald acting as agent and/or principal in privately negotiated and/or at-the-market transactions. During the three months ended March 31, 2005, we sold approximately 1.0 million shares of common stock pursuant to this agreement and we received net proceeds of approximately $10.0 million. On March 15, 2005, Diana Statutory Trust I, or the Trust, was created for the sole purpose of issuing and selling preferred securities in the amount of $50.0 million. We received proceeds, net of debt issuance costs, from the preferred securities offering in the amount of $48.4 million.

Mortgage-Backed Securities

At March 31, 2005, we held $4.5 billion of mortgage-backed securities at fair value, net of unrealized gains of $324 thousand and unrealized losses of $106.1 million. At December 31, 2004, we held $4.8 billion of mortgage-backed securities at fair value, net of unrealized gains of $772 thousand and unrealized losses of $70.1 million. The

decrease in mortgage-backed securities held is primarily due to principal payments of $332.0 million during the three months ended March 31, 2005 and an increase in net unrealized losses of $36.8 million due to the increase in market interest rates. At March 31, 2005 and December 31, 2004, substantially all of the mortgage-backed securities in our portfolio were purchased at a premium to their par value and our portfolio had a weighted-average amortized cost of 101.7% of face amount.

Fair value was below amortized cost for certain of the securities held at March 31, 2005 and December 31, 2004. At March 31, 2005 and December 31, 2004, all of our portfolio that had unrealized losses was invested in AAA-rated non-agency-backed or agency-backed mortgage-backed securities. None of the securities held had been downgraded by a credit rating agency since their purchase. In addition, we intend and have the ability to hold the securities for a period of time, to maturity if necessary, sufficient to allow for the anticipated recovery in fair value of the securities held. As such, we do not believe any of the securities held are other-than-temporarily impaired at March 31, 2005 and December 31, 2004.

The stated contractual final maturity of the mortgage loans underlying our portfolio of mortgage-backed securities ranges up to 30 years. However, the expected maturities are subject to change based on the prepayments of the underlying mortgage loans. The following table sets forth the maturity dates, by year, and percentage composition related to the AAA-rated non-agency-backed and agency-backed mortgage-backed securities assets in our investment portfolio at March 31, 2005:


	Weighted-Average		% of
Asset	Final Maturity		Total
Adjustable-Rate Mortgage-Backed Securities		2033		2.6	%
Hybrid Adjustable-Rate Mortgage-Backed Securities		2034		96.1
Balloon Mortgage-Backed Securities		2008		1.2
Fixed-Rate Mortgage-Backed Securities		N/A		N/A

The following table sets forth the maturity dates, by year, and percentage composition related to the assets that comprise our investment portfolio at December 31, 2004:


	Weighted-Average		% of
Asset	Final Maturity		Total
Adjustable-Rate Mortgage-Backed Securities		2033		2.6	%
Hybrid Adjustable-Rate Mortgage-Backed Securities		2034		96.3
Balloon Mortgage-Backed Securities		2008		1.1
Fixed-Rate Mortgage-Backed Securities		N/A		N/A

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

The principal payment rate on our mortgage-backed securities, an annual rate of principal paydowns for our mortgage-backed securities relative to the outstanding principal balance of our mortgage-backed securities, was 25% for the three months ended March 31, 2005 and December 31, 2004. The principal payment rate attempts to predict the percentage of principal that will paydown over the next 12 months based on historical principal paydowns. The principal payment rate cannot be considered an indication of future principal repayment rates because actual changes in interest rates will have a direct impact on the principal prepayments in our portfolio.

At March 31, 2005 and December 31, 2004, the weighted-average effective duration of the securities in our overall investment portfolio, assuming constant prepayment rates, or CPR, to the balloon or reset date, or the CPB duration, was 1.74 years and 1.69 years, respectively. CPR is a measure of the rate of prepayment for our mortgage-backed securities, expressed as an annual rate relative to the outstanding principal balance of our mortgage-backed securities. CPB duration is similar to CPR except that it also assumes that the hybrid adjustable-rate mortgage-backed securities prepay in full at their next reset date. At March 31, 2005 and December 31, 2004, assuming a 25% principal payment rate, the mortgages underlying our hybrid adjustable-rate mortgage-backed securities had fixed

interest rates for a weighted-average of approximately 27 months and 29 months, respectively, after which time the interest rates reset and become adjustable. The average length of time until maturity of those mortgages was 30 years. Those mortgages are also subject to interest rate caps that limit the amount that the applicable interest rate can increase during any year, known as an annual cap, and through the maturity of the applicable security, known as a lifetime cap. At March 31, 2005 and December 31, 2004, the mortgages underlying our hybrid adjustable-rate mortgage-backed securities with specific annual caps had average annual caps of 2.26% and 2.24%, respectively, and average lifetime caps of 9.99%.

The following table summarizes our AAA-rated non-agency-backed and agency-backed mortgage-backed securities, excluding other securities, at March 31, 2005, according to their estimated weighted-average life classifications:


					Weighted-
					Average
Weighted-Average Life	Fair Value		Amortized Cost		Coupon
(in thousands)
Less than one year	$	600,010	$	610,882		3.58	%
Greater than one year and less than five years		3,853,112		3,948,327		4.31
Greater than five years		—		—		—


Total	$	4,453,122	$	4,559,209		4.21	%

The following table summarizes our mortgage-backed securities at December 31, 2004 according to their estimated weighted-average life classifications:


					Weighted-
					Average
Weighted-Average Life	Fair Value		Amortized Cost		Coupon
(in thousands)
Less than one year	$	211,475	$	215,099		3.76	%
Greater than one year and less than five years		4,616,480		4,682,154		4.24
Greater than five years		—		—		—


Total	$	4,827,955	$	4,897,253		4.22	%

The weighted-average lives of the mortgage-backed securities at March 31, 2005 and December 31, 2004 in the tables above are based upon data provided through a subscription-based financial information service provided by a major investment bank, assuming constant prepayment rates to the balloon or reset date for each security. At March 31, 2005 and December 31, 2004, the weighted-average lives were calculated using estimated prepayment speeds or actual prepayment speed history. The weighted-average lives for some of the mortgage-backed securities included in the table above were estimated using expected prepayment speeds for pools with similar characteristics, since certain pools were new issues and did not have historical performance data available. The prepayment model considers current yield, forward yield, steepness of the yield curve, current mortgage rates, the mortgage rate of the outstanding loan, loan age, margin and volatility.

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

Equity Securities

Our investment policies allow us to acquire a limited amount of equity securities, including common and preferred shares issued by other real estate investment trusts. At March 31, 2005 and December 31, 2004, we did not hold any such equity securities.

Unsettled Securities Purchases

At March 31, 2005 and December 31, 2004, we had no unsettled security trades.

Other Assets

We had other assets of $30.3 million and $33.4 million at March 31, 2005 and December 31, 2004, respectively. Other assets at March 31, 2005 consist primarily of interest receivable of $17.7 million, principal receivable of $11.0 million and a common stock investment in a subsidiary trust of $1.6 million. Other assets at December 31, 2004 consist primarily of interest receivable of $18.9 million, principal receivable of $13.4 million, prepaid directors’ and officers’ liability insurance of $137 thousand, deferred financing costs of $174 thousand and deferred compensation of $732 thousand. The decreases in interest receivable and principal receivable from December 31, 2004 is primarily due to principal payments on our mortgage-backed securities portfolio.

Hedging Instruments

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

At March 31, 2005 and December 31, 2004, we have engaged in short sales of Eurodollar futures contracts as a means of mitigating our interest rate risk on forecasted interest expense associated with the benchmark rate on forecasted rollover/reissuance of repurchase agreements or the interest rate repricing of repurchase agreements, or hedged item, for a specified future time period, which is defined as the calendar quarter immediately following the contract expiration date. At March 31, 2005, we had short positions on 4,065 Eurodollar futures contracts, which expire in June 2004, December 2005 and March 2006, with a notional amount totaling $4.1 billion. The value of these futures contracts is marked-to-market daily in our margin account with the custodian. Based upon the daily market value of these futures contracts, we either receive funds into, or wire funds into, our margin account with the custodian to ensure that an appropriate margin account balance is maintained at all times through the expiration of the contracts. At December 31, 2004, we had short positions on 4,740 Eurodollar futures contracts, which expire(d) in March 2005, June 2005, December 2005 and March 2006 with a notional amount totaling $4.7 billion. At March 31, 2005 and December 31, 2004, the fair value of the Eurodollar futures contracts was $5.5 million recorded in assets and $1.1 million recorded in liabilities, respectively.

At March 31, 2005, we have entered into interest rate swap contracts to mitigate our interest rate risk for the period defined by maturity of the interest rate swap. Cash flows that occur each time the swap is repriced are associated with forecasted interest expense for a specified future period, which is defined as the calendar period preceding each repricing date with the same number of months as the repricing frequency. At March 31, 2005 and December 31, 2004, the current notional amount of interest rate swap contracts totaled $1.6 billion and the fair value of the interest rate swap contracts at those dates was $9.9 million and $7.9 million, respectively, recorded in assets. Counterparties to our interest rate swap contracts are well-known financial institutions and default risk is considered low.

Liabilities

We have entered into repurchase agreements to finance some of our acquisitions of mortgage-backed securities. None of the counterparties to these agreements are affiliates of Seneca or us. These agreements are secured by our mortgage-backed securities and bear interest rates that have historically moved in close relationship

to LIBOR. At March 31, 2005 and December 31, 2004, we had established 17 borrowing arrangements with various investment banking firms and other lenders, 12 of which were in use at March 31, 2005 and December 31, 2004.

At March 31, 2005, we had outstanding $4.0 billion of repurchase agreements with a weighted-average current borrowing rate of 2.66%, $166.7 million of which matures within 30 days, $3.6 billion of which matures between 31 and 90 days and $250.0 million of which matures in greater than 90 days. At December 31, 2004, we had outstanding $4.4 billion of repurchase agreements with a weighted-average current borrowing rate of 2.38%, $230.4 million of which matures within 30 days, $1.9 billion of which matures between 31 and 90 days and $2.3 billion of which matures in greater than 90 days. The decrease in outstanding repurchase agreements is primarily due to the use of cash flows from principal and interest payments to repay repurchase agreement liabilities. It is our present intention to seek to renew the repurchase agreements outstanding at March 31, 2005 as they mature under the then-applicable borrowing terms of the counterparties to our repurchase agreements. At March 31, 2005 and December 31, 2004, the repurchase agreements were secured by mortgage-backed securities with an estimated fair value of $4.2 billion and $4.6 billion, respectively, and had a weighted-average maturity of 90 days and 133 days, respectively. The net amount at risk, defined as the sum of the fair value of securities sold plus accrued interest income minus the sum of repurchase agreement liabilities plus accrued interest expense, with all counterparties was $178.8 million and $205.9 million at March 31, 2005 and December 31, 2004, respectively.

On March 15, 2005, we issued junior subordinated notes to our wholly owned subsidiary, Diana Statutory Trust I, in the amount of $51.6 million. At March 31, 2005, junior subordinated notes, net of debt issuance costs, were $50.0 million and accrued interest payable on the junior subordinated notes was $175 thousand. See Note 11 to the financial statements for further discussion about the junior subordinated notes.

The weighted-average days to rate reset of our total liabilities was 228 days and 275 days at March 31, 2005 and December 31, 2004, respectively. The decrease in the weighted-average days to rate reset of our total liabilities is primarily attributed to the decrease in weighted-average rate reset of our repurchase agreements and a shortening of the term of derivative contracts.

We had $44.1 million and $36.8 million of other liabilities at March 31, 2005 and December 31, 2004, respectively. Other liabilities at March 31, 2005 consisted primarily of $13.8 million of cash distribution payable, $28.2 million of accrued interest expense on repurchase agreements and junior subordinated notes, $1.0 million of accounts payable and accrued expenses and $1.1 million of management compensation payable, incentive compensation payable and other related party liabilities. Other liabilities at December 31, 2004 consisted primarily of $16.0 million of cash distribution payable, $17.3 million of accrued interest expense on repurchase agreements and interest rate swap contracts and $3.0 million of management compensation payable, incentive compensation payable and other related party liabilities.

We have a margin lending facility with our primary custodian from which we may borrow money in connection with the purchase or sale of securities. The terms of the borrowings, including the rate of interest payable, are agreed to with the custodian for each amount borrowed. Borrowings are repayable upon demand by the custodian. No borrowings were outstanding under the margin lending facility at March 31, 2005 and December 31, 2004.

Stockholders’ Equity

Stockholders’ equity at March 31, 2005 and December 31, 2004 was $387.9 million and $405.5 million, respectively, which included $105.8 million and $69.3 million, respectively, of net unrealized losses on mortgage-backed securities available-for-sale and $11.0 million and $7.9 million, respectively, of net deferred realized and unrealized gains on cash flow hedges presented as accumulated other comprehensive loss.

Weighted-average stockholders’ equity and return on average equity for the three months ended March 31, 2005 and 2004 were $415.6 and $302.5 million, respectively, and 18.51% and 14.36%, respectively. Return on average equity is defined as annualized net income divided by weighted-average stockholders’ equity.

Our book value at March 31, 2005 was as follows:


	Total
	Stockholders’			Book Value per
(in thousands, except per share amounts)	Equity			Share ⁽¹⁾
Total stockholders’ equity (GAAP)	$	387,880		$	10.15
Addback/(Subtract)
Accumulated other comprehensive loss on mortgage-backed securities		105,788			2.76
Accumulated other comprehensive income on interest rate swap contracts		(9,675	)		(0.25	)

Total stockholders’ equity, excluding accumulated other comprehensive income and loss on mortgage-backed securities and interest rate swap contracts (NON-GAAP)	$	483,993		$	2.66

(1)

Based on 38,228,817 shares outstanding at March 31, 2005.

Our book value at December 31, 2004 was as follows:


	Total
	Stockholders’			Book Value per
(in thousands, except per share amounts)	Equity			Share ⁽¹⁾
Total stockholders’ equity (GAAP)	$	405,503		$	10.93
Addback/(Subtract)
Accumulated other comprehensive loss on mortgage-backed securities		69,298			1.86
Accumulated other comprehensive income on interest rate swap contracts		(7,748	)		(0.21	)

Total stockholders’ equity, excluding accumulated other comprehensive income and loss on mortgage-backed securities and interest rate swap contracts (NON-GAAP)	$	467,053		$	12.58

(1)

Based on 37,113,011 shares outstanding at December 31, 2004.

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

Results of Operations

For the three months ended March 31, 2005 and 2004, net income was $19.0 million or $0.51 per weighted-average share outstanding (basic and diluted) and $10.8 million or $0.43 per weighted-average share outstanding (basic and diluted), respectively. For the same periods, interest income, net of premium amortization, was approximately $42.5 million and $20.2 million, respectively, and was primarily earned from investments in mortgage-backed securities. Interest expense for the three months ended March 31, 2005 and 2004 was $20.5 million and $6.8 million, respectively, and was primarily due to costs of short-term borrowings. The increase in net income, interest income, net of premium amortization, and interest expense is primarily due to our increase in asset base as a result of the follow-on public offering completed in March 2004.

For the three months ended March 31, 2005 and 2004, the weighted-average yield on average earning assets, net of amortization of premium, was 3.65% and 3.20%, respectively, and our cost of funds on our repurchase agreement liabilities and junior subordinated notes was 1.91% and 1.20%, respectively, resulting in a net interest spread of 1.74% and 2.00%, respectively. Cost of funds is defined as total interest expense divided by average repurchase agreement liabilities and junior subordinated notes. Refer to the section titled “Critical Accounting Policies” for a description of our accounting policy for derivative instruments and hedging activities and the impact on interest expense. Interest expense for the three months ended March 31, 2005 and 2004 was calculated as follows:


				Percentage					Percentage
	Three Months			of Average			Three Months		of Average
	Ended			Repurchase			Ended		Repurchase
	March 31,			Agreement			March 31,		Agreement
(in thousands)	2005			Liabilities			2004		Liabilities
Interest expense on repurchase agreement liabilities	$	26,498			2.47	%	$	6,812		1.20	%
Net hedge ineffectiveness (gains)/losses on futures and interest rate swap contracts		(592	)		(0.06	)		14	nm
Amortization of net realized gains on futures contracts		(4,728	)		(0.44	)		—		—
Net interest income on interest rate swap contracts		(819	)		(0.08	)		—		—
Interest expense on junior subordinated notes		178			0.02			—		—
Other		2		nm				1	nm

Total interest expense	$	20,539			1.91	%	$	6,827		1.20	%

nm = not meaningful

Average repurchase agreement liabilities and junior subordinated notes during the three months ended March 31, 2005 and 2004 were $4.3 billion and $2.3 billion, respectively.

Operating expenses for the three months ended March 31, 2005 and 2004 were $3.0 million and $2.6 million, respectively.

Base management compensation to Seneca, which was $1.1 million and $787 thousand for the three months ended March 31, 2005 and 2004, respectively, is based on a percentage of our average net worth. “Average net worth” for these purposes is calculated on a monthly basis and equals the difference between the aggregate book value of our consolidated assets prior to accumulated depreciation and other non-cash items, including the fair market value adjustment on mortgage-backed securities, minus the aggregate book value of our consolidated liabilities. The increase in base management fees is primarily the result of the increase in our average net worth as a result of the follow-on public offering completed in March 2004.

Incentive compensation expense to related parties for the three months ended March 31, 2005 and 2004 was $470 thousand and $846 thousand, respectively. The decrease in expense is primarily related to the New Management Agreement signed on March 26, 2005, which revised the computation of incentive compensation paid to Seneca. Under the New Management Agreement, no incentive compensation was earned by Seneca for the three months ended March 31, 2005. The incentive compensation expense of $470 thousand for the three months ended March 31, 2005 relates to restricted common stock awards granted for incentive compensation earned in prior periods that vested during the period. For the three months ended March 31, 2004, total incentive compensation earned by Seneca was $1.3 million, one-half payable in cash and one-half payable in the form of our common stock. The cash portion of the incentive compensation of $652 thousand for the three months ended March 31, 2004 was expensed in the period as well as 15.2% of the restricted common stock portion of the incentive compensation, or $99 thousand. In accordance with the terms of his employment agreement, our chief financial officer is eligible to earn incentive compensation. No incentive compensation was earned by our chief financial officer for the three months ended March 31, 2005. For the three months ended March 31, 2004, total incentive compensation earned by our chief financial officer was $65 thousand. This portion of the incentive compensation was also payable one-half in cash and one-half in the form of a restricted stock award under our 2003 Stock Incentive Plan. The cash portion of the incentive compensation of $33 thousand for the three months ended March 31, 2004 was expensed in that period as well as 15.2% of the restricted stock portion of the incentive compensation, or $5 thousand. The remaining incentive compensation for the three months ended March 31, 2004 consists primarily of the change in fair value of unvested restricted stock awards.

Salaries and benefits expense for the three months ended March 31, 2005 and 2004 was $208 thousand and $96 thousand, respectively. The increase is primarily due to increased employee headcount.

Professional services expense for the three months ended March 31, 2005 and 2004 was $562 thousand and $417 thousand, respectively, and includes legal, accounting and other professional services provided to us.

REIT taxable net income is calculated according to the requirements of the Internal Revenue Code, rather than GAAP. The following table reconciles GAAP net income to REIT taxable net income for the three months ended March 31, 2005 and 2004:


	Three Months Ended
	March 31,
(in thousands)	2005			2004
GAAP net income	$	18,969		$	10,800
Adjustments to GAAP net income:
Amortization of organizational costs		(8	)		(8	)
Addback unvested stock compensation expense for unvested options		1			2
Addback of stock compensation expense for unvested restricted common stock		507			161
Subtract stock compensation expense for vested restricted stock		(106	)		—
Addback/(subtract) net hedge ineffectiveness (gains)/losses on futures and interest rate swap contracts		(708	)		10
Subtract dividend equivalent rights on restricted stock		(182	)		(12	)
Subtract amortization of net realized gains on futures contracts		(4,728	)		—
Subtract net realized losses on futures contracts		(4	)		(412	)

Net adjustments to GAAP net income/(loss)		(5,228	)		(259	)


REIT taxable net income	$	13,741		$	10,541

Undistributed REIT taxable net income for the three months ended March 31, 2005 and 2004 was as follows:


	Three Months Ended
	March 31,
(in thousands, except per share data)	2005			2004
Undistributed REIT taxable net income, beginning of period	$	1,791		$	281
REIT taxable net income earned during period		13,741			10,541
Distributions declared during period, net of dividend equivalent rights on restricted stock		(13,588	)		(10,422	)

Undistributed REIT taxable net income, end of period	$	1,944		$	400


Cash distributions per share declared during period	$	0.36		$	0.42

Percentage of REIT taxable net income distributed		98.9	%		98.9	%

We believe that these presentations of our REIT taxable net income are useful to investors because they are directly related to the distributions we are required to make in order to retain our REIT status and to the calculations of the incentive compensation payable to related parties (before deducting incentive compensation, net operating losses and certain other items). There are limitations associated with REIT taxable net income, and by itself it is an incomplete measure of our financial performance over any period. As a result, our REIT taxable net income should be considered in addition to, and not as a substitute for, our GAAP-based net income as a measure of our financial performance.

Contractual Obligations and Commitments

As of March 31, 2005, our day-to-day operations were externally managed pursuant to the New Management Agreement with Seneca, subject to the direction and oversight of our board of directors. See Note 6 to the financial statements for significant terms of the New Management Agreement.

Off-Balance Sheet Arrangements

Since inception, we have not maintained any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Further, we have not guaranteed any obligations of unconsolidated entities nor do we have any commitment or intent to provide additional funding to any such entities. Accordingly, we are not materially exposed to any market, credit, liquidity or financing risk that could arise if we had engaged in such relationships.

On March 15, 2005, Diana Statutory Trust I was created for the sole purpose of issuing and selling preferred securities. Diana Statutory Trust I is a special purpose entity. See Note 1 to the financial statements included in Item 1 of this Quarterly Report on Form 10-Q for further discussion.

Liquidity and Capital Resources

Our primary source of funds at March 31, 2005 consisted of repurchase agreements totaling $4.0 billion with a weighted-average current borrowing rate of 2.66% which we used to finance acquisition of mortgage-related assets. We expect to continue to borrow funds in the form of repurchase agreements. At March 31, 2005, we had established 17 borrowing arrangements with various investment banking firms and other lenders, 12 of which were in use on March 31, 2005. Increases in short-term interest rates could negatively impact the valuation of our mortgage-related assets, which could limit our borrowing ability or cause our lenders to initiate margin calls. Amounts due upon maturity of our repurchase agreements will be funded primarily through the rollover/reissuance of repurchase agreements and monthly principal and interest payments received on our mortgage-backed securities. We generally seek to borrow between eight and 12 times the amount of our equity. Our leverage ratio, defined as total repurchase agreements plus junior subordinated notes divided by total stockholders’ equity, at March 31, 2005 was 10.5.

We have a margin lending facility with our primary custodian from which we may borrow money in connection with the purchase or sale of securities. The terms of the borrowings, including the rate of interest payable, are agreed to with the custodian for each amount borrowed. Borrowings are repayable upon demand by the custodian. At March 31, 2005, no borrowings were outstanding under the margin lending facility.

For liquidity, we also rely on cash flows from operations, primarily monthly principal and interest payments to be received on our mortgage-backed securities, as well as any primary securities offerings authorized by our board of directors.

On March 31, 2005, we declared a cash distribution of $0.36 to our stockholders of record on April 12, 2005. We will pay the distribution on May 20, 2005. The distribution is a taxable dividend and is not considered a return of capital. Distributions are funded with cash flows from our ongoing operations, including principal and interest payments received on our mortgage-backed securities. We did not distribute $1.8 million of our REIT taxable net income for the year ended December 31, 2004. We intend to declare a spillback distribution in this amount during 2005.

We believe that equity capital, combined with the cash flows from operations and the utilization of borrowings, will be sufficient to enable us to meet anticipated liquidity requirements. However, an increase in interest rates substantially above our expectations could cause a liquidity shortfall. If our cash resources are at any time insufficient to satisfy our liquidity requirements, we may be required to liquidate mortgage-backed securities or sell debt or additional equity securities. If required, the sale of mortgage-backed securities at prices lower than the carrying value of such assets would result in losses and reduced income. During the three months ended March 31, 2005, we had adequate cash flow, liquid assets and unpledged collateral with which to meet our margin requirements.

We intend to increase our capital resources by making additional offerings of equity and debt securities, possibly including classes of preferred stock, common stock, commercial paper, medium-term notes, collateralized mortgage obligations and senior or subordinated notes. Such financings will depend on market conditions for capital

raises and for the investment of any net proceeds therefrom. All debt securities, other borrowings, and classes of preferred stock will be senior to the common stock in a liquidation of our Company.

On January 3, 2005, we filed a shelf registration statement on Form S-3 with the SEC. This registration statement was declared effective by the SEC on January 21, 2005. Under the shelf registration statement, we may offer and sell any combination of common stock, preferred stock, warrants to purchase common stock or preferred stock and debt securities in one or more offerings up to total proceeds of $500.0 million. Each time we offer to sell securities, a supplement to the prospectus will be provided containing specific information about the terms of that offering. At March 31, 2005, total proceeds of up to $490.0 million remain available to us to offer and sell under this shelf registration statement.

On February 7, 2005, we entered into a Controlled Equity Offering Sales Agreement with Cantor Fitzgerald & Co., or Cantor Fitzgerald, through which we may sell common stock or preferred stock from time to time through Cantor Fitzgerald acting as agent and/or principal in privately negotiated and/or at-the-market transactions. During the three months ended March 31, 2005, approximately 1.0 million shares of common stock were sold pursuant to this agreement and we received net proceeds of approximately $10.0 million.

Inflation

Virtually all of our assets and liabilities are financial in nature. As a result, interest rates and other factors influence our performance far more so than does inflation. Changes in interest rates do not necessarily correlate with inflation rates or changes in inflation rates. Our financial statements are prepared in accordance with accounting principles generally accepted in the United States and our distributions are determined by our board of directors based primarily by our net income as calculated for tax purposes; in each case, our activities and balance sheet are measured with reference to historical cost and or fair market value without considering inflation.

Risk Factors

As used in this Quarterly Report, “Luminent,” “company,” “we,” “our,” and “us,” refer to Luminent Mortgage Capital, Inc., except where the context otherwise requires.

Interest rate mismatches between our mortgage-backed securities and the borrowings used to fund our purchases of mortgage-backed securities might reduce our net income or result in losses during periods of changing interest rates.

We invest primarily in adjustable-rate and hybrid adjustable-rate mortgage-backed securities. The mortgages underlying these adjustable-rate mortgage-backed securities have interest rates that reset periodically, typically every six months or on an annual basis, based upon market-based indices of interest rates such as U.S. Treasury bonds or LIBOR, the interest rate that banks in London offer for deposits in London of U.S. dollars. The mortgages underlying hybrid adjustable-rate mortgage-backed securities have interest rates that are fixed for the first few years of the loan — typically three, five, seven or 10 years — and thereafter their interest rates reset periodically similar to the mortgages underlying adjustable-rate mortgage-backed securities. We have primarily funded our acquisitions, and expect to fund our future acquisitions, of adjustable-rate and hybrid adjustable-rate mortgage-backed securities in part with borrowings that have interest rates based on indices and repricing terms similar to, but with shorter maturities than, the interest rate indices and repricing terms of our adjustable-rate and hybrid adjustable-rate mortgage-backed securities. At March 31, 2005, 98.7% of our investment portfolio was invested in adjustable-rate or hybrid adjustable-rate mortgage-backed securities having a weighted-average term to next rate adjustment of approximately 35 months, while our borrowings had a weighted-average term to next rate adjustment of approximately 60 days. After consideration of the duration on our Eurodollar futures and interest rate swap contracts, our weighted-average maturity of our total liabilities was 228 days. The phrase “weighted average term to next rate adjustment” refers to the average of the periods of time that must elapse before the interest rates adjust for all of the mortgages underlying our adjustable-rate and hybrid adjustable-rate mortgage-backed securities in our portfolio, which average is weighted in proportion to the book values of the applicable securities. During periods of

changing interest rates, this interest rate mismatch between our assets and liabilities could reduce or eliminate our net income and distributions to our stockholders and could cause us to suffer a loss.

Accordingly, in a period of rising interest rates, we could experience a decrease in, or elimination of, our net income or a net loss because the interest rates on our borrowings could increase faster than the interest rates on our adjustable-rate mortgage-backed securities. Conversely, in a period of declining interest rates, we could experience a decrease in, or elimination of, our net income or a net loss because our amortization of premiums could increase.

Increased levels of prepayments on the mortgages underlying our mortgage-backed securities might decrease our net interest income or result in a net loss.

The mortgage-backed securities that we acquire generally represent interests in pools of mortgage loans. The principal and interest payments we receive from our mortgage-backed securities are generally funded by the payments that mortgage borrowers make on those underlying mortgage loans. When borrowers prepay their mortgage loans sooner than expected, corresponding prepayments on the mortgage-backed securities occur sooner than expected by the marketplace. Sooner-than-expected prepayments could harm our results of operations in the following ways, among others:

	•	We seek to purchase mortgage-backed securities that we believe to have favorable risk-adjusted expected returns relative to market interest rates at the time of purchase. If the coupon interest rate for a mortgage-backed security is higher than the market interest rate at the time it is purchased, then that mortgage-backed security will be acquired at a premium to its par value.

	•	In accordance with applicable accounting rules, we are required to amortize any premiums or accrete discounts related to our mortgage-backed securities over their expected terms. The amortization of a premium reduces interest income, while the accretion of a discount increases interest income. The expected terms for mortgage-backed securities are a function of the prepayment rates for the mortgages underlying the mortgage-backed securities. Mortgage-backed securities that are at a premium to their par value are more likely to experience prepayment of some or all of their principal through refinancings. If the mortgages underlying our mortgage-backed securities purchased at a premium are prepaid in whole or in part more quickly than their respective maturity dates, then we must also amortize their respective premiums more quickly, which would decrease our net interest income and harm our profitability.

	•	A substantial portion of our adjustable-rate mortgage-backed securities may bear interest at rates that are lower than their “fully-indexed rates,” which refers to their applicable index rates 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.

	•	If we are unable to acquire new mortgage-backed securities to replace the prepaid mortgage-backed securities, our financial condition, results of operations and cash flow may suffer and we could incur losses.

Prepayment rates generally increase when interest rates decline and decrease when interest rates rise; however, changes in prepayment rates may lag behind changes in interest rates and are difficult to predict. Prepayment rates also may be affected by other factors, including, without limitation, conditions in the housing and financial markets, general economic conditions and the relative interest rates on adjustable-rate and fixed-rate mortgage loans. While we seek to minimize prepayment risk, we must balance prepayment risk against other risks and the potential returns of each investment when selecting investments. No strategy can completely insulate us from prepayment or other such risks.

We depend on short-term 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 or at all, we will be limited in our ability to acquire mortgage-related assets, which will harm our results of operations.

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. We depend on a few lenders to provide the primary credit facilities for our purchases of mortgage-related assets. In addition, our existing indebtedness may limit our ability to make additional borrowings. If our lenders do not allow us to renew our borrowings or we cannot replace maturing borrowings on favorable terms or at all, we might have to sell our mortgage-related assets under adverse market conditions, which would harm our results of operations and may result in losses.

Our leverage strategy increases the risks of our operations, which could reduce our net income and the amount available for distributions or cause us to suffer a loss.

We generally seek to borrow between eight and 12 times the amount of our equity, although at times our borrowings may be above or below this amount. We incur this indebtedness by borrowing against a substantial portion of the market value of our mortgage-backed securities. Our total indebtedness, however, is not expressly limited by our policies and depends on our and our prospective lender’s estimate of the stability of our portfolio’s cash flow. We face the risk that we might not be able to meet our debt service obligations or a lender’s margin requirements from our income and, to the extent we cannot, we might be forced to liquidate some of our assets at disadvantageous prices. Our use of leverage amplifies the risks associated with other risk factors, which could reduce our net income and the amount available for distributions or cause us to suffer a loss. For example:

	•	A majority of our borrowings are secured by our mortgage-backed securities, generally under repurchase agreements. A decline in the market value of our 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 our mortgage-backed securities, we would experience losses.

	•	A default under a mortgage-related asset that constitutes collateral for a loan could also result in an involuntary liquidation of the mortgage-related asset, including any cross-collateralized mortgage-backed securities. This circumstance would result in a loss to us to the extent that the value of our mortgage-related asset upon liquidation is less than the amount we borrowed against the mortgage-related asset.

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

	•	If we experience losses as a result of our leverage policy, such losses would reduce the amounts available for distribution to our stockholders.

We may incur increased borrowing costs related to repurchase agreements that would harm our results of operations.

Our borrowing costs under repurchase agreements are generally adjustable and 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 a number of factors, including, without limitation, the following:

	•	the movement of interest rates;

	•	the availability of financing in the market; and

	•	the value and liquidity of our mortgage-backed securities.

Most of our borrowings are collateralized borrowings in the form of repurchase agreements. If the interest rates on these repurchase agreements increase, our results of operations will be harmed and we may have losses.

We have only been in business since June 2003 and our implementation of our operating policies and strategies may not continue to be successful.

We began operations in June 2003, and therefore have a limited operating history. Our results of operations depend on many factors, including the availability of opportunities to acquire mortgage-related assets, the level and volatility of interest rates, readily accessible short- and long-term funding alternatives in the financial markets and economic conditions. Moreover, delays in fully leveraging and investing the net proceeds of our public offerings may cause our performance to be weaker than other fully leveraged and invested mortgage REITs pursuing comparable investment strategies. Furthermore, we face the risk that our implementation of our operating policies and strategies may not continue to be successful.

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

Our board of directors has the authority to modify or waive our current operating policies and our strategies, including our election to operate as a REIT, without prior notice and without stockholder approval. We cannot predict the effect any changes to our current operating policies and strategies would have on our business, operating results and value of our stock. However, the effects might be adverse.

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 the Seneca personnel who provide management services to us for the selection, acquisition, structuring, monitoring and sale of our mortgage-related assets and the borrowings used to acquire these assets. Our key officers include Gail P. Seneca, S. Trezevant Moore, Jr. and Christopher J. Zyda. We have not entered into employment agreements with our key officers other than Mr. Moore, who is our President and Chief Operating Officer, and Mr. Zyda, who is our Senior Vice President and Chief Financial Officer. With the exception of Ms. Seneca, all of our senior officers devote all of their business time to our business. In addition, our management agreement with Seneca pursuant to which Ms. Seneca provides management services to us is terminable by Seneca at any time upon 60 days’ notice. The loss of our key officers or the termination of our management agreement with Seneca could harm our business, financial condition, cash flow and results of operations.

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

Our net income depends on our ability to acquire mortgage-backed securities at favorable spreads over our borrowing costs. In acquiring mortgage-backed securities, 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-backed securities, many of which have greater financial resources than we do. As a result, we may not be able to acquire sufficient mortgage-backed securities at favorable spreads over our borrowing costs, which would harm our results of operations.

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

The mortgages underlying our mortgage-backed securities are typically subject to periodic and lifetime interest rate caps. Periodic interest rate caps limit the amount that the interest rate of a mortgage can increase during any given period. Lifetime interest rate caps limit the amount an interest rate can increase through the maturity of a mortgage. At March 31, 2005, 98.7% of our mortgage-backed securities were based on adjustable-rate or hybrid adjustable-rate mortgages, of which 76.8% were subject to interest rate caps. As of that same date, the percentage of

adjustable-rate and hybrid adjustable-rate mortgage-backed securities in our investment portfolio which are subject to periodic interest rate caps every six months or annually were 17.4% and 82.6%, respectively.

Our borrowings are not subject to similar restrictions. The periodic adjustments to the interest rates of the mortgages underlying our mortgage-backed securities are based on changes in an objective index. Substantially all of the mortgages underlying our mortgage-backed securities adjust their interest rates based on one of two main indices, the U.S. Treasury index, which is a monthly or weekly average yield of benchmark U.S. Treasury securities published by the Federal Reserve Board, or LIBOR. The percentages of the mortgages underlying the adjustable-rate and hybrid adjustable-rate mortgage-backed securities in our investment portfolio at March 31, 2005 with interest rates that reset based on the U.S. Treasury or LIBOR indices were 37.7% and 62.3%, respectively.

Accordingly, in a period of rapidly increasing interest rates, the interest rates paid on our borrowings could increase without limitation while interest rate caps could limit the increases in the yields on our mortgage-backed securities. This problem is magnified for mortgage-backed securities that are not fully indexed. Further, some of the mortgages underlying our 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 may receive less cash income on our mortgage-backed securities than we need to pay interest on our related borrowings. These factors could reduce our net interest income or cause us to suffer a net loss.

We might experience reduced net interest income or a loss from holding fixed-rate investments during periods of rising interest rates.

A significant portion of our investment portfolio consists of hybrid adjustable-rate mortgage-backed securities. At March 31, 2005, 96.1% of our investment portfolio consisted of hybrid adjustable-rate mortgage-backed securities. We may also invest in fixed-rate mortgage-backed securities from time to time, however, at March 31, 2005, none of our portfolio consisted of fixed-rate mortgage-backed securities. We fund our acquisition of fixed-rate mortgage-backed securities, including those based on balloon maturity and hybrid adjustable-rate mortgages, in part with short-term repurchase agreements and term loans. During periods of rising interest rates, our costs associated with borrowings used to fund the acquisition of fixed-rate mortgage-backed securities are subject to increases, while the income we earn from these assets remains substantially fixed. The reduction or elimination of the net interest spread between the fixed-rate mortgage-backed securities that we purchase and our borrowings used to purchase them would reduce our net interest income and could cause us to suffer a loss.

We might not be able to use derivatives to mitigate our interest rate and prepayment risks.

Our policies permit us to enter into interest rate swaps, caps and floors and other derivative transactions in an effort to reduce our interest rate and prepayment risks. These transactions might mitigate our interest rate and prepayment risks, but cannot eliminate these risks. Moreover, the use of derivative transactions could have a negative impact on our net income and our status as a REIT and, therefore, our use of such derivatives could be limited.

We may enter into ineffective derivative transactions or other hedging activities that may reduce our net interest rate spread or cause us to suffer losses.

Our policies permit us, but we are not required, to enter into derivative transactions such as interest rate swaps, caps and floors and other derivative transactions to help us seek to reduce our interest rate and prepayment risks. The effectiveness of any derivative transaction will depend significantly upon whether we correctly quantify the interest rate or prepayment risks being hedged, our execution of and ongoing monitoring of our hedging activities and the treatment of such hedging activities under generally accepted accounting principles in the United States, or GAAP.

In the case of these hedges, and any other efforts to mitigate the effects of interest rate changes on our liability costs, if we enter into hedging instruments that have higher interest rates embedded in them as a result of the forward yield curve, and at the end of the term of these hedging instruments the spot market interest rates for the liabilities that we hedged are actually lower, then we will have locked in higher interest rates for our liabilities than

would be available in the spot market at the time, which could result in a narrowing of our net interest rate spread or result in losses. In some situations, we may sell assets or hedging instruments at a loss in order to maintain adequate liquidity.

In addition, we apply Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended and interpreted, and record derivatives at fair value. If the derivatives meet the criteria to be accounted for as hedging transactions, the effects of the transactions could be materially different as to timing than if they do not qualify as hedges, which may cause a narrowing of our net interest rate spread or result in losses.

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

We use changes in 10-year U.S. Treasury yields as a reference indicator for changes in interest rates because it is a common market benchmark. Increases in the general level of interest rates can cause the fair market value of our assets to decline, particularly those mortgage-backed securities whose underlying mortgages have fixed-rate components. Our fixed-rate mortgage-backed securities and our hybrid adjustable-rate mortgage-backed securities (during the fixed-rate component of the mortgages underlying such securities) will generally be more negatively affected by such increases than our adjustable-rate mortgage-backed securities. In accordance with GAAP, we will be required to reduce the carrying value of our mortgage-backed securities by the amount of any decrease in the fair value of our mortgage-backed securities compared to their respective amortized costs. If unrealized losses in fair value occur, we will have to either reduce current earnings or reduce stockholders’ equity without immediately affecting current earnings, depending on how we classify such mortgage-backed securities under GAAP. In either case, our net book value will decrease to the extent of any realized or unrealized losses in fair value.

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

We may acquire leveraged mortgage derivative securities that expose us to a high level of interest rate risk. The characteristics of leveraged mortgage derivative securities cause those securities to experience greater volatility in their market prices. Thus, acquisition of leveraged mortgage derivative securities will expose us to the risk of greater volatility in our portfolio, which could reduce our net income and harm our overall results of operations.

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, we might be compelled to liquidate particular assets at inopportune times and at disadvantageous prices.

Possible market developments, including a sharp or prolonged rise in interest rates, an increase in prepayment rates or increasing market concern about the value or liquidity of one or more types of mortgage-backed securities in which our portfolio is concentrated, might reduce the market value of our portfolio, which might cause our lenders to require additional collateral. Any requirement for additional collateral might compel us to liquidate our assets at inopportune times and at disadvantageous prices, thereby harming our operating results. If we sell our mortgage-backed securities at prices lower than their carrying value, we would experience losses.

Because the assets that we acquire might experience periods of illiquidity, we might be prevented from selling our mortgage-related assets at opportune times and prices.

We bear the risk of being unable to dispose of our mortgage-related assets at advantageous times and prices or in a timely manner because mortgage-related assets generally experience periods of illiquidity. The lack of liquidity might result from the absence of a willing buyer or an established market for these assets, as well as legal or contractual restrictions on resale. If we are unable to sell our mortgage-related assets at opportune times, we might suffer a loss and/or reduce our distributions.

We remain subject to losses despite our strategy of investing in highly-rated mortgage-backed securities.

Our investment guidelines provide that at least 90% of our assets must be invested in mortgage-backed securities that are either agency-backed or are rated at least investment grade by at least one nationally recognized statistical rating agency. While highly-rated mortgage-backed securities are generally subject to a lower risk of default than lower credit quality mortgage-backed securities and may benefit from third-party credit enhancements such as insurance or corporate guarantees, there is no assurance that such mortgage-backed securities will not be subject to credit losses. Furthermore, ratings are subject to change over time as a result of a number of factors, including greater than expected delinquencies, defaults or credit losses or a deterioration in the financial strength of corporate guarantors, any of which may reduce the market value of such securities. Furthermore, ratings do not take into account the reasonableness of the issue price, interest risks, prepayment risks, extension risks or other risks associated with such mortgage-backed securities. As a result, while we attempt to mitigate our exposure to credit risk on a relative basis by focusing on highly-rated mortgage-backed securities, we cannot eliminate such credit risks and remain subject to other risks to our investment portfolio and may suffer losses, which may harm the market price of our common stock.

Our investment guidelines permit us to invest up to 10% of our assets in unrated mortgage-related assets and mortgage-backed securities rated below investment-grade, which carry a greater likelihood of default or rating downgrade than investments in investment-grade mortgage-backed securities and may cause us to suffer losses.

Our investment guidelines allow us to invest up to 10% of our assets in lower credit quality mortgage-related assets, including mortgage-backed securities that are not rated at least investment grade by at least one nationally-recognized statistical rating organization, and other investments such as leveraged mortgage derivative securities, shares of other REITs, mortgage loans or other mortgage-related investments. Non-investment-grade mortgage-backed securities, which may include residual mortgage-backed securities, are more likely to incur losses because the mortgages underlying those securities are made to borrowers possessing lower-quality credit. While all mortgage-backed securities are subject to a risk of default, that risk is greater with non-investment grade mortgage-backed securities. In addition, the rating agencies are more likely to downgrade the credit quality of those securities, which would reduce the value of those securities.

Our use of repurchase agreements to borrow funds may give our lenders greater rights in the event that either we or any of our lenders file 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 if 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 any of our lenders files for bankruptcy. Thus, the use of repurchase agreements exposes our pledged assets to risk in the event of a bankruptcy filing by any of our lenders or us.

Defaults on the mortgage loans underlying our mortgage-backed securities may reduce the value of our investment portfolio and may harm our results of operations.

We bear the risk of any losses resulting from any defaults on the mortgage loans underlying the mortgage-backed securities in our investment portfolio. Many of the mortgage-backed securities that we acquire have one or more forms of credit enhancement provided by third parties, such as insurance against risk of loss due to default on the underlying mortgage loans or bankruptcy, fraud and special hazard losses. To the extent that third parties have agreed to insure against these types of losses, the value of such insurance will depend in part on the creditworthiness and claims-paying ability of the insurer and the timeliness of reimbursement in the event of a default on the underlying obligations. Further, the insurance coverage for various types of losses is limited in amount, and we would bear losses in excess of these limitations.

Other mortgage-backed securities that we purchase are subject to limited guarantees of the payment of limited amounts of principal and interest on mortgage loans underlying such mortgage-backed securities, either by federal government agencies, including Ginnie Mae, by federally-chartered corporations, including Fannie Mae and Freddie Mac, or by other corporate guarantors. While Ginnie Mae’s obligations are backed by the full faith and credit of the United States, the obligations of Fannie Mae and Freddie Mac and other corporate guarantors are solely their own.

As a result, a substantial deterioration in the financial strength of Fannie Mae, Freddie Mac or other corporate guarantors could increase our exposure to future delinquencies, defaults or credit losses on our holdings of Fannie Mae or Freddie Mac-backed mortgage-backed securities or other corporate-backed mortgage-backed securities, and could harm our results of operations. In addition, while Freddie Mac guarantees the eventual payment of principal, it does not guarantee the timely payment thereof, and our results of operations may be harmed if borrowers are late or delinquent in their payments on mortgages underlying Freddie Mac-backed mortgage-backed securities. Moreover, Fannie Mae, Freddie Mac, Ginnie Mae and other corporate guarantees relate only to payments of limited amounts of principal and interest on the mortgages underlying such agency-backed or corporate-backed securities, and do not guarantee the market value of such mortgage-backed securities or the yields on such mortgage-backed securities. As a result, we remain subject to interest rate risks, prepayment risks, extension risks and other risks associated with our investment in such mortgage-backed securities and may experience losses in our investment portfolio.

Decreases in the value of the property underlying our mortgage-backed securities might decrease the value of our assets.

The mortgage-backed securities in which we invest are secured by underlying real property interests. To the extent that the value of the property underlying our mortgage-backed securities decreases, our security might be impaired, which might decrease the value of our assets.

Insurance will not cover all potential losses on the underlying real property and the absence thereof may harm the value of our assets.

Under our asset acquisition policy, we are permitted to invest up to a maximum of 10% of our total assets in assets other than agency-backed securities, or rated as at least investment grade by a nationally recognized statistical rating agency. Mortgage loans that fall outside of this category of investments under our investment guidelines are subject to the 10% limitation. If we elect to purchase mortgage loans, we may require that each of the mortgage loans that we purchase include comprehensive insurance covering the underlying real property, including liability, fire and extended coverage. Certain types of losses, however, generally of a catastrophic nature, such as earthquakes, floods and hurricanes, may be uninsurable or not economically insurable. Inflation, changes in building codes and ordinances, environmental considerations and other factors might also make it infeasible to use insurance proceeds to replace a property if it is damaged or destroyed. Under such circumstances, the insurance proceeds, if any, might not be adequate to restore the economic value of the underlying real property, which might impair our security and decrease the value of our assets.

Distressed mortgage loans have a higher risk of future default.

If we elect to purchase mortgage loans, we may purchase distressed mortgage loans as well as mortgage loans that have had a history of delinquencies. These distressed mortgage loans may be in default or may have a greater than normal risk of future defaults and delinquencies, compared to a pool of newly-originated, high quality loans of comparable type, size and geographic concentration. Returns on an investment of this type depend on accurate pricing of such investment, the borrower’s ability to make required payments or, in the event of default, the ability of the loan’s servicer to foreclose and liquidate the mortgage loan. We cannot assure you that the servicer will be able to liquidate a defaulted mortgage loan in a cost-effective manner, at an advantageous price or in a timely manner.

Subordinated loans on real estate are subject to higher risks.

If we elect to purchase mortgage loans, we may acquire loans secured by commercial properties, including loans that are subordinated to first liens on the underlying commercial real estate. Subordinated mortgage loans are subject to greater risks of loss than first lien mortgage loans. An overall decline in the real estate market could reduce the value of the real property securing such loans such that the aggregate outstanding balance of the second-lien loan and the outstanding balance of the more senior loan on the real property exceed the value of the real property.

Risks Related to Seneca

We pay Seneca incentive compensation based on our portfolio’s performance. This arrangement may lead Seneca to recommend riskier or more speculative investments in an effort to maximize its incentive compensation.

In addition to its base management compensation, Seneca earns incentive compensation for each fiscal year equal to a specified percentage if the return on assets, as defined in the management agreement, for any such fiscal year exceeds the threshold return, defined as the average of the weekly values for any period of the sum of the 10-year U.S. Treasury rate for such period plus 2% The percentage for this calculation is the weighted-average of the following percentages based on our applicable average net worth, as defined in the management agreement for the fiscal year:

	•	0.35% for the first $750 million of applicable average net worth;

	•	0.20% for the next $750 million of applicable average net worth; and

	•	0.15% for the applicable average net worth in excess of $1.5 billion.

As Seneca evaluates different mortgage-backed securities and other investments for our account, there is a risk that Seneca will cause us to assume more risk than is prudent in an attempt to increase its incentive compensation. Other key criteria related to determining appropriate investments and investment strategies, including the preservation of capital, might be under-weighted if Seneca focuses exclusively or disproportionately on maximizing its incentive income from us.

Because Seneca is entitled to a significant fee if we terminate the management agreement, economic considerations might preclude us from terminating the management agreement in the event that Seneca fails to meet our expectations.

In March 2005, we executed an Amended and Restated Management Agreement, dated as of March 1, 2005, with Seneca. If we terminate the management agreement without cause or because we decide to manage our company internally then we may have to pay a significant fee to Seneca. The amount of the termination fee shall be equal to two times the amount of the highest annual base management compensation and the highest annual incentive management compensation, for a particular year, earned by Seneca during any of the three years (or on an annualized basis if a lesser period) preceding the effective date of the termination, multiplied by a fraction, where the numerator is the positive difference (if any) resulting from thirty-six (36) minus the number of months (rounded to the nearest whole month) between the effective date of the management agreement and the termination date, and the denominator is thirty-six (36). After March 2008, there would be no termination or internalization fees.

The actual amount of such fee cannot be known at this. Paying this fee would reduce significantly the cash available for distribution to our stockholders and might cause us to suffer a net operating loss. Consequently, terminating the management agreement might not be advisable even if we determine that it would be more efficient to operate with an internal management structure or if we are otherwise dissatisfied with Seneca’s performance.

Seneca’s liability is limited under the management agreement, and we have agreed to indemnify Seneca against certain liabilities.

Seneca has not assumed any responsibility to us other than to render the services described in the management agreement, and is not responsible for any action of our board of directors in declining to follow Seneca’s advice or recommendations. Seneca and its directors, officers and employees will not be liable to us for acts performed by its officers, directors or employees in accordance with and pursuant to the management agreement, except for acts constituting gross negligence, recklessness, willful misconduct or active fraud in connection with their duties under the management agreement. We have agreed to indemnify Seneca and its directors, officers and employees with respect to all expenses, losses, damages, liabilities, demands, charges and claims arising from acts of Seneca not constituting gross negligence, recklessness, willful misconduct or active fraud.

Seneca might allocate mortgage-related opportunities to other entities, and thus might divert attractive investment opportunities away from us.

Our operations and assets are managed by specified individuals at Seneca. Seneca and those individuals, including some of our officers, manage mortgage and other portfolios for parties unrelated to us. These multiple responsibilities might create conflicts of interest for Seneca and these individuals if they are presented with opportunities that might benefit us and Seneca’s other clients. Seneca and these individuals must allocate investments among our portfolio and their other clients by determining the entity or account for which the investment is most suitable. In making this determination, Seneca and these individuals consider the investment strategy and guidelines of each entity or account with respect to the acquisition of assets, leverage, liquidity and other factors that Seneca and these individuals determine to be appropriate. However, Seneca and those working on its behalf have no obligation to make any specific investment opportunities available to us and the above-mentioned conflicts of interest might result in decisions or allocations of investments that are not in our or our stockholders’ best interests.

Seneca may render services to other mortgage investors, which could reduce the amount of time and effort that Seneca devotes to us.

Our management agreement with Seneca does not restrict the right of Seneca or any persons working on its behalf to carry on their respective businesses, including the rendering of advice to others regarding the purchase of mortgage-backed securities that would meet our investment criteria. In addition, the management agreement does not specify a minimum time period that Seneca and its personnel must devote to managing our investments. The ability of Seneca to engage in these other business activities, and specifically to manage mortgage-related assets for third parties, could reduce the time and effort it spends managing our portfolio to the detriment of our investment returns.

Seneca has significant influence over our affairs, and might cause us to engage in transactions that are not in our or our stockholders’ best interests.

In addition to managing us and having one of its officers as a member of our board, Seneca provides advice on our operating policies and strategies. Seneca may also cause us to engage in future transactions with Seneca and its affiliates, subject to the approval of, or guidelines approved by, the independent members of our board of directors. Our directors, however, rely primarily on information supplied by Seneca in reaching their determinations. Accordingly, Seneca has significant influence over our affairs, and may cause us to engage in transactions that are not in our or our stockholders’ best interests.

Seneca has limited experience managing a REIT and we cannot assure you that Seneca’s past experience will be sufficient to manage our business as a REIT successfully.

Seneca has limited experience managing a REIT, and limited experience in complying with the income, asset and other limitations imposed by the REIT provisions of the Internal Revenue Code. Those provisions are complex and the failure to comply with those provisions in a timely manner could cause us to lose our qualification as a REIT or could force us to pay unexpected taxes and penalties. In such event, our net income would be reduced and we could incur a loss.

Investors may not be able to estimate with certainty the aggregate fees and expense reimbursements that will be paid to Seneca under the management agreement and the cost-sharing agreement due to the time and manner in which Seneca’s incentive compensation and expense reimbursements are determined.

Seneca may be entitled to substantial fees pursuant to the management agreement. Seneca’s base management compensation is calculated as a percentage of our applicable average net worth. Seneca’s incentive compensation is calculated as a tiered percentage of the excess of our return on assets for any fiscal year exceeds the threshold return and is indeterminable in advance of a particular period. Since future payments of base management compensation, incentive compensation and expense

reimbursements are determined at future dates based upon our then-applicable average net worth, results of operations and actual expenses incurred by Seneca, such fees and expense reimbursements cannot be estimated with mathematical certainty. Any base management compensation, incentive compensation or expense reimbursements payable to Seneca may be materially greater or less than the historical amounts and we can provide no assurance at this time as to the amount of any such base management compensation, incentive compensation or expense reimbursements that may be payable to Seneca in the future.

Legal and Tax Risks

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

Qualification as a REIT involves the application of highly technical and complex U.S. federal income tax code provisions for which only a limited number of judicial or administrative interpretations exist. Accordingly, it is not certain we will be able to remain qualified as a REIT for U.S. federal income tax purposes. Even a technical or inadvertent mistake could jeopardize our REIT status. Furthermore, Congress or the Internal Revenue Service (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 in a particular tax year. If we fail to qualify as a REIT in any tax year, then:

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

	•	any resulting tax liability could be substantial, would reduce the amount of cash available for distribution to stockholders, and could force us to liquidate assets at inopportune times, causing lower income or higher losses than would result if these assets were not liquidated; and

	•	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 our stockholders would be reduced for each of the years during which we did not qualify as a REIT.

Even if we remain qualified as a REIT, we might face other tax liabilities that reduce our cash flow. Further, we might be subject to federal, state and local taxes on our income and property. Any of these taxes would decrease cash available for distribution to our stockholders.

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

In order to qualify as a REIT for U.S. federal income tax purposes, we must satisfy tests concerning, among other things, our sources of income, the nature and diversification of our mortgage-backed securities, the amounts we distribute to our stockholders and the ownership of our stock. We may also be required to make distributions to our stockholders at disadvantageous times or when we do not have funds readily available for distribution. Thus, compliance with REIT requirements may cause us to forego opportunities we would otherwise pursue.

In addition, the REIT provisions of the Internal Revenue Code impose a 100% tax on income from “prohibited transactions.” Prohibited transactions generally include sales of assets that constitute inventory or other property held for sale in the ordinary course of a business, other than foreclosure property. This 100% tax could impact our desire to sell mortgage-backed securities at otherwise opportune times if we believe such sales could be considered a prohibited transaction.

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

The existing REIT provisions of the Internal Revenue Code substantially limit our ability to hedge mortgage-backed securities and related borrowings. Under these provisions, our annual income from qualified hedges, together with any other income not generated from qualified REIT real estate assets, is limited 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, we might in the future have to limit our use of advantageous hedging techniques, which could leave us exposed to greater risks associated with changes in interest rates than we would otherwise want to bear. If we fail to satisfy the 25% or 5% limitations, unless our failure was due to reasonable cause and we meet certain other technical requirements, we could lose our REIT status for federal income tax purposes. Even if our failure were due to reasonable cause, we might have to pay a penalty tax equal to the amount of our income in excess of certain thresholds, multiplied by a fraction intended to reflect our profitability.

Complying with the REIT requirements may force us to borrow to make distributions to our 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 might 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 might be greater than our cash flow available for distribution to our stockholders. If we do not have other funds available in these situations, we might be unable to distribute 90% of our taxable income as required by the REIT rules. In that case, we would need to borrow funds, sell a portion of our mortgage-backed securities potentially at disadvantageous prices or find another alternative source of funds. These alternatives could increase our costs or reduce our equity and reduce amounts available to invest in mortgage-backed securities.

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

In order to qualify as a REIT, we must 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, generally, no more than 5% of the value of our assets can consist of the securities of any one issuer. If we fail to comply with these requirements, we could lose our REIT status unless we are able to avail ourselves of certain relief provisions. Under certain relief provisions, we would be subject to penalty taxes.

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

We intend to conduct our business so as not to become regulated as an investment company under the Investment Company Act of 1940, as amended. If we fail to qualify for this exemption, our ability to use leverage would be substantially reduced and we would be unable to conduct our business as described in

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 current interpretation of the SEC, in order to qualify for this exemption, we must maintain at least 55% of our assets directly in these qualifying real estate interests. Mortgage-backed securities that do not represent all of the certificates issued with respect to an underlying pool of mortgages may be treated as 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 provisions of the Investment Company Act.

In satisfying the 55% requirement under the Investment Company Act, we treat as qualifying interests mortgage-backed securities issued with respect to an underlying pool as to which we hold all issued certificates. If the SEC adopts a contrary interpretation of such treatment, we could be required to sell a substantial amount of our mortgage-backed securities under potentially adverse market conditions. Further, in our attempts to ensure that we at all times qualify for the exemption under the Investment Company Act, we might be precluded from acquiring mortgage-backed securities if their yield is higher than the yield on mortgage-backed securities that could be purchased in a manner consistent with the exemption. These factors may lower or eliminate our net income.

Misplaced reliance on legal opinions or statements by issuers of mortgage-backed securities could result in a failure to comply with REIT income or assets tests.

When purchasing mortgage-backed securities, we may rely on opinions of counsel for the issuer or sponsor of such securities, or statements made in related offering documents, for purposes of determining whether and to what extent those securities constitute REIT real estate assets for purposes of the REIT asset tests and produce income that qualifies under the REIT gross income tests. The inaccuracy of any such opinions or statements may adversely affect our REIT qualification and result in significant corporate-level tax.

One-action rules may harm the value of the underlying property.

Several states have laws that prohibit more than one action to enforce a mortgage obligation, and some courts have construed the term “action” broadly. In such jurisdictions, if the judicial action is not conducted according to law, there may be no other recourse in enforcing a mortgage obligation, thereby decreasing the value of the underlying property.

We may be harmed by changes in various laws and regulations.

Changes in the laws or regulations governing Seneca may impair Seneca’s ability to perform services in accordance with the management agreement. Our business may be harmed by changes to the laws and regulations affecting our manager, Seneca, or us, including changes to securities laws and changes to the Internal Revenue Code applicable to the taxation of REITs. New legislation may be enacted into law or new interpretations, rulings or regulations could be adopted, any of which could harm us, Seneca and our stockholders, potentially with retroactive effect.

Legislation was recently enacted that reduces the maximum tax rate of non-corporate taxpayers for capital gains (for taxable years ending on or after May 6, 2003 and before January 1, 2009) and for dividends (for taxable years beginning after December 31, 2002 and before January 1, 2009) to 15%. Generally, dividends paid by REITs are not eligible for the new 15% federal income tax rate, with certain exceptions discussed under “United States Federal Income Tax Considerations — Taxation of Taxable United States Stockholders” and “— Distributions Generally.” Although this legislation does not adversely affect the taxation of REITs or dividends paid by REITs, the more favorable treatment of regular corporate dividends could cause investors who are individuals to consider stocks of other corporations that pay dividends as more attractive relative to stocks of REITs.

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 Internal Revenue Code. If we realize excess inclusion income and allocate it to our stockholders, this income cannot be offset by net operating losses. If the stockholder is a tax-exempt entity, then this income would be fully taxable as unrelated business taxable income under Section 512 of the Internal Revenue Code. If the stockholder is foreign, it would be subject to U.S. 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 real estate mortgage investment conduit, or 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 our stockholders. Furthermore, some types of tax-exempt entities, including voluntary employee benefit associations and entities that have borrowed funds to acquire our common stock, may be required to treat a portion of or all of the distributions they may receive from us as unrelated business taxable income. Finally, we may invest in equity securities of other REITs and it is possible that we might receive excess inclusion income from those investments.

Risks Related to Investing in Our Securities

We have not established a minimum distribution payment level, and we cannot assure you of our ability to make distributions to our stockholders in the future.

Our policy is to make quarterly distributions to our stockholders in amounts such that we distribute all or substantially all of our taxable income in each year, subject to certain adjustments, which, along with other factors, should enable us to qualify for the tax benefits accorded to a REIT under the Internal Revenue Code. We have not established a minimum distribution payment level and our ability to make distributions might be harmed by the risk factors described herein. 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. We cannot assure you that we will have the ability to make distributions to our stockholders in the future.

Our declared cash distributions may force us to liquidate mortgage-backed securities or borrow additional funds.

From time to time, our board of directors will declare cash distributions. These distribution declarations are irrevocable. If we do not have sufficient cash to fund distributions, we will need to liquidate mortgage- backed securities or borrow funds by entering into repurchase agreements or otherwise borrowing funds under our margin lending facility to pay the distribution. If required, the sale of mortgage-backed securities at prices lower than the carrying value of such assets would result in losses. Additionally, if we were to borrow funds on a regular basis to make distributions, it is likely that our results of operations and our stock price would be harmed.

Future offerings of debt securities by us, 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 distributions, may harm the value 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 our 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. Additional equity offerings by us may dilute the holdings of our existing stockholders or reduce the value of our common stock, or both. Our preferred stock, if issued, would have a preference on distributions that could limit our ability to make distributions 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 and diluting their stock holdings in us.

Changes in yields may harm the market price of our common stock.

Our earnings are derived primarily from the expected positive spread between the yield on our assets and the cost of our borrowings. This spread will not necessarily be larger in high interest rate environments than in low interest rate environments and may also be negative. In addition, during periods of high interest rates, our net income and, therefore, the amount of any distributions on our common stock, might be less attractive compared to alternative investments of equal or lower risk. Each of these factors could harm the market price of our common stock.

The market price and trading volume of our common stock may be volatile.

The market price of our common stock may be volatile and be subject to wide fluctuations. In addition, the trading volume in our common stock may fluctuate and cause significant price variations to occur. If the market price of our common stock declines significantly, you may be unable to resell your shares at or above your purchase price. We cannot assure you that the market price of our common stock will not fluctuate or decline significantly in the future. Some of the factors that could negatively affect our stock price or result in fluctuations in the price or trading volume of our common stock include:

	•	actual or anticipated variations in our quarterly operating results or distributions;

	•	changes in our funds from operations or earnings estimates or publication of research reports about us or the real estate industry;

	•	increases in market interest rates that lead purchasers of our shares to demand a higher yield;

	•	changes in market valuations of similar companies;

	•	adverse market reaction to any indebtedness we incur in the future;

	•	additions or departures of key management personnel;

	•	the termination of or resignation by Seneca as our manager;

	•	actions by institutional stockholders;

	•	speculation in the press or investment community; and

	•	general market and economic conditions.

Issuance of large amounts of our stock could cause our price to decline.

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

Restrictions on ownership of a controlling percentage of our capital stock might limit your opportunity to receive a premium on our stock.

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. The constructive ownership rules in our charter are complex and may cause our 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 our outstanding stock by an individual or entity could cause that individual or entity to own constructively in excess of 9.8% of our outstanding stock, and thus be subject to the ownership limit in our charter. Any attempt to own or transfer shares of our common or preferred stock in excess of the ownership limit without the consent of our board of directors is void, and will result in the shares being transferred by operation of law to a charitable trust. These provisions might inhibit market activity and the resulting opportunity for our stockholders to receive a premium for their shares that might otherwise exist if any person were to attempt to assemble a block of our stock in excess of the number of shares permitted under our charter and that may be in the best interests of our stockholders.

Broad market fluctuations could harm the market price of our common stock.

The stock market has experienced price and volume fluctuations that have affected the market price of many companies in industries similar or related to ours and that have been unrelated to these companies’ operating performances. These broad market fluctuations could reduce the market price of our common stock. Furthermore, our operating results and prospects may be below the expectations of public market analysts and investors or may be lower than those of companies with comparable market capitalizations, which could harm the market price of our common stock.

Certain provisions of Maryland law and our charter and bylaws could hinder, delay or prevent a change in control of our company.

Certain provisions of Maryland law, our charter and our bylaws have the effect of discouraging, delaying or preventing transactions that involve an actual or threatened change in control of our company. These provisions include the following:

	•	Classified Board of Directors. Our board of directors is divided into three classes with staggered terms of office of three years each. The classification and staggered terms of office of our directors make it more difficult for a third party to gain control of our board of directors. At least two annual meetings of stockholders, instead of one, generally would be required to effect a change in a majority of our board of directors.

	•	Removal of Directors. Under our charter, subject to the rights of one or more classes or series of preferred stock to elect one or more directors, a director may be removed only for cause and only by the affirmative vote of at least two-thirds of all votes entitled to be cast by our stockholders generally in the election of directors.

	•	Number of Directors, Board Vacancies, Term of Office. We have elected to be subject to certain provisions of Maryland law that vest in our board of directors the exclusive right to determine the number of directors and the exclusive right, by the affirmative vote of a majority of the remaining directors, to fill vacancies on the board even if the remaining directors do not constitute a quorum. These provisions of Maryland law, which are applicable even if other provisions of Maryland law or our charter or bylaws provide to the contrary, also provide that any director elected to fill a vacancy shall hold office for the remainder of the full term of the class of directors in which the vacancy occurred, rather than the next annual meeting of stockholders as would otherwise be the case, and until his or her successor is elected and qualifies.

	•	Limitation on Stockholder-Requested Special Meetings. Our bylaws provide that our stockholders have the right to call a special meeting only upon the written request of stockholders entitled to cast not less than a majority of all the votes entitled to be cast by our stockholders at such meeting.

	•	Advance Notice Provisions for Stockholder Nominations and Proposals. Our bylaws require advance written notice for stockholders to nominate persons for election as directors at, or to bring other business before, any meeting of our stockholders. This bylaw provision limits the ability of our stockholders to make nominations of persons for election as directors or to introduce other proposals unless we are notified in a timely manner prior to the meeting.

	•	Exclusive Authority of our Board to Amend our Bylaws. Our bylaws provide that our board of directors has the exclusive power to adopt, alter or repeal any provision of our bylaws or to make new bylaws. Thus, our stockholders may not effect any changes to our bylaws.

	•	Preferred Stock. Under our charter, our board of directors has authority to issue preferred stock from time to time in one or more series and to establish the terms, preferences and rights of any such series of preferred stock, all without approval of our stockholders.

	•	Duties of Directors with Respect to Unsolicited Takeovers. Maryland law provides protection for Maryland corporations against unsolicited takeovers by limiting, among other things, the duties of the directors in unsolicited takeover situations. The duties of directors of Maryland corporations do not require them to (1) accept, recommend or respond to any proposal by a person seeking to acquire control of the corporation, (2) authorize the corporation to redeem any rights under, or modify or render inapplicable, any stockholder rights plan, (3) make a determination under the Maryland Business Combination Act or the Maryland Control Share Acquisition Act, or (4) act or fail to act solely because of the effect the act or failure to act may have on an acquisition or potential acquisition of control of the corporation or the amount or type of consideration that may be offered or paid to the stockholders in an acquisition. Moreover, under Maryland law, the act of the directors of a Maryland corporation relating to or affecting an acquisition or potential acquisition of

		control is not subject to any higher duty or greater scrutiny than is applied to any other act of a director. Maryland law also contains a statutory presumption that an act of a director of a Maryland corporation satisfies the applicable standards of conduct for directors under Maryland law.

	•	Ownership Limit. In order to preserve our status as a REIT under the Internal Revenue Code, our charter generally prohibits any single stockholder, or any group of affiliated stockholders, from beneficially owning more than 9.8% of our outstanding common and preferred stock unless our board of directors waives or modifies this ownership limit.

	•	Maryland Business Combination Act. The Maryland Business Combination Act provides that, unless exempted, a Maryland corporation may not engage in business combinations, including mergers, dispositions of 10% or more of its assets, certain issuances of shares of stock and other specified transactions, with an “interested stockholder” or an affiliate of an interested stockholder for five years after the most recent date on which the interested stockholder became an interested stockholder, and thereafter unless specified criteria are met. An interested stockholder is generally a person owning or controlling, directly or indirectly, 10% or more of the voting power of the outstanding stock of a Maryland corporation. Our board of directors has adopted a resolution exempting our company from this statute. However, our board of directors may repeal or modify this resolution in the future, in which case the provisions of the Maryland Business Combination Act would be applicable to business combinations between our company and interested stockholders.

	•	Maryland Control Share Acquisition Act. Maryland law provides that “control shares” of a corporation acquired in a “control share acquisition” shall have no voting rights except to the extent approved by a vote of two-thirds of the votes eligible to be cast on the matter under the Maryland Control Share Acquisition Act. “Control shares” means shares of stock that, if aggregated with all other shares of stock previously acquired by the acquirer, would entitle the acquirer to exercise voting power in electing directors within one of the following ranges of the voting power: one-tenth or more but less than one-third, one-third or more but less than a majority or a majority or more of all voting power. A “control share acquisition” means the acquisition of control shares, subject to certain exceptions. If voting rights of control shares acquired in a control share acquisition are not approved at a stockholders’ meeting, then, subject to certain conditions and limitations, the corporation may redeem any or all of the control shares for fair value. If voting rights of such control shares are approved at a stockholders’ meeting and the acquirer becomes entitled to vote a majority of the shares of stock entitled to vote, all other stockholders may exercise appraisal rights. Our bylaws contain a provision exempting acquisitions of our shares from the Maryland Control Share Acquisition Act. However, our board of directors may amend our bylaws in the future to repeal or modify this exemption, in which case any control shares of our company acquired in a control share acquisition will be subject to the Maryland Control Share Acquisition Act.

The market price of our common stock may be adversely affected by future sales of a substantial number of shares of our common stock by our existing stockholders in the public market or the availability of such shares for sale.

We cannot predict the effect, if any, of future sales of our common stock, or the availability of shares for future sales, on the market price of our common stock. Sales of substantial amounts of shares of our common stock, or the perception that these sales could occur, may harm prevailing market prices for our common stock.

Subject to Rule 144 volume limitations applicable to our affiliates, substantially all of our 38,228,817 shares of common stock outstanding as of March 31, 2005 are eligible for immediate resale by their holders. If any of our stockholders were to sell a large number of shares in the public market, the sale could reduce the market price of our common stock and could impede our ability to raise future capital through a sale of additional equity securities.

Terrorist attacks and other acts of violence or war may affect the market for our common stock, the industry in which we operate and our operations and profitability.

Terrorist attacks may harm our results of operations and your investment. We cannot assure you that there will not be further terrorist attacks against the United States, U.S. businesses or elsewhere in the world. These attacks or

armed conflicts may impact the property underlying our mortgage-backed securities, directly or indirectly, by undermining economic conditions in the United States. Losses resulting from terrorist events are generally uninsurable.

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

The primary component of our market risk is interest rate risk as described below. While we do not seek to avoid risk completely, we do seek to assume risk that can be quantified from historical experience, to manage that risk, to earn sufficient compensation to justify taking those risks and to maintain capital levels consistent with the risks we undertake or to which we are exposed.

Interest Rate Risk

We are subject to interest rate risk in connection with our investments in fixed-rate, adjustable-rate and hybrid adjustable-rate mortgage-backed securities and our related debt obligations, which are generally repurchase agreements of limited duration that are periodically refinanced at current market rates, and our derivative contracts.

Effect on Net Interest Income

We fund our investments in some long-term, fixed-rate and hybrid adjustable-rate mortgage-backed securities with short-term borrowings under repurchase agreements. During periods of rising interest rates, the borrowing costs associated with those fixed-rate and hybrid-adjustable rate mortgage-backed securities tend to increase while the income earned on such fixed-rate and hybrid adjustable-rate mortgage-backed securities (during the fixed-rate component of such securities) may remain substantially unchanged. This effect results in a narrowing of the net interest spread between the related assets and borrowings and may even result in losses.

As a means to mitigate the negative impact of a rising interest rate environment, we have entered into derivative transactions, specifically Eurodollar futures contracts and interest rate swaps. Hedging techniques are based, in part, on assumed levels of prepayments of our fixed-rate and hybrid adjustable-rate mortgage-backed securities. If prepayments are slower or faster than assumed, the life of the mortgage-backed securities will be longer or shorter, which would reduce the effectiveness of any hedging strategies we may utilize and may result in losses on such transactions. Hedging strategies involving the use of derivative securities are highly complex and may produce volatile returns. Our hedging activity is also limited by the asset and sources-of-income requirements applicable to us as a REIT.

Extension Risk

We invest in fixed-rate and hybrid adjustable-rate mortgage-backed securities. Hybrid adjustable-rate mortgage-backed securities have interest rates that are fixed for the first few years of the loan — typically three, five, seven or 10 years — and thereafter their interest rates reset periodically on the same basis as adjustable-rate mortgage-backed securities. As of March 31, 2005, 96.1% of our investment portfolio was comprised of hybrid adjustable-rate mortgage-backed securities. We compute the projected weighted-average life of our fixed-rate and hybrid adjustable-rate mortgage-backed securities based on the market’s assumptions regarding the rate at which the borrowers will prepay the underlying mortgages. In general, when a fixed-rate or hybrid adjustable-rate mortgage-backed security is acquired with borrowings, we may, but are not required to, enter into an interest rate swap agreement or other hedging instrument that effectively fixes our borrowing costs for a period close to the anticipated average life of the fixed-rate portion of the related mortgage-backed security. This strategy is designed to protect us from rising interest rates because the borrowing costs are fixed for the duration of the fixed-rate portion of the related mortgage-backed security. However, if prepayment rates decrease in a rising interest rate environment, the life of the fixed-rate portion of the related mortgage-backed security could extend beyond the term of the swap agreement or other hedging instrument. This situation could negatively impact us as borrowing costs would no longer be fixed after the end of the hedging instrument while the income earned on the fixed-rate or hybrid adjustable-rate mortgage-backed security would remain fixed. This situation may also cause the market value of our fixed-rate and hybrid adjustable-rate mortgage-backed securities to decline with little or no offsetting gain from the

related hedging transactions. In extreme situations, we may be forced to sell assets and incur losses to maintain adequate liquidity.

Adjustable-Rate and Hybrid Adjustable-Rate Mortgage-Backed Security Interest Rate Cap Risk

We also invest in adjustable-rate and hybrid adjustable-rate mortgage-backed securities, that are based on mortgages that are typically subject to periodic and lifetime interest rate caps. These caps limit the amount by which an adjustable-rate or hybrid adjustable-rate mortgage-backed security’s interest yield may change during any given period. However, our borrowing costs pursuant to our repurchase agreements are not subject to similar restrictions. Therefore, in a period of increasing interest rates, interest rate costs on our borrowings could increase without limitation by caps, while the interest-rate yields on our adjustable-rate and hybrid adjustable-rate mortgage-backed securities would effectively be limited by caps. This problem will be magnified to the extent we acquire adjustable-rate and hybrid adjustable-rate mortgage-backed securities that are not based on mortgages that are fully-indexed. In addition, the underlying mortgages may be subject to periodic payment caps that result in some portion of the interest being deferred and added to the principal outstanding. The presence of caps could result in our receipt of less cash income on our adjustable-rate and hybrid adjustable-rate mortgage-backed securities than we need in order to pay the interest cost on our related borrowings. These factors could lower our net interest income or cause a net loss during periods of rising interest rates, which would negatively impact our financial condition, cash flows and results of operations.

Interest Rate Mismatch Risk

We fund a substantial portion of our acquisitions of adjustable-rate and hybrid adjustable-rate mortgage-backed 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 the mortgage-backed securities. 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 our mortgage assets and liabilities. Therefore, our cost of funds would likely rise or fall more quickly than would our earnings rate on assets. During periods of changing interest rates, such interest rate mismatches could negatively impact our financial condition, cash flows and results of operations. To mitigate interest rate mismatches, we may utilize hedging strategies discussed above and in Note 10 to our financial statements included in Item 1of this Quarterly Report on Form 10-Q.

Our analysis of risks is based on management’s experience, estimates, models and assumptions. These analyses rely on models that utilize estimates of fair value and interest rate sensitivity. Actual economic conditions or implementation of investment decisions by our manager may produce results that differ significantly from our expectations.

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 for mortgage-backed securities generally increase when prevailing interest rates fall below the market rate existing when the underlying mortgages were originated. In addition, prepayment rates on adjustable-rate and hybrid adjustable-rate mortgage-backed securities generally increase when the difference between long-term and short-term interest rates declines or becomes negative. Prepayments of mortgage-backed securities could harm our results of operations in several ways. Some adjustable-rate mortgages underlying our adjustable-rate mortgage-backed securities may bear initial “teaser” interest rates that are lower than their “fully-indexed” rates, which refers to the applicable index rates plus a margin. In the event that such an adjustable-rate mortgage is prepaid prior to or soon after the time of adjustment to a fully-indexed rate, the holder of the related mortgage-backed security would have held such security while it was less profitable and lost the opportunity to receive interest at the fully-indexed rate over the expected life of the adjustable-rate mortgage-backed security. Although we currently do not own any adjustable-rate mortgage-backed securities with “teaser” rates, we may obtain some in the future that would expose us to this prepayment risk. In addition, we currently own mortgage-backed securities that were purchased at a premium. The prepayment of such mortgage-backed securities at a rate faster than anticipated would result in a write-off of any remaining capitalized

premium amount and a consequent 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 flow and results of operations could be negatively impacted.

Effect on Fair Value

Another component of interest rate risk is the effect changes in interest rates will have on the market value of our assets. We face the risk that the market value of our assets will increase or decrease at different rates than that of our liabilities, including our hedging instruments.

We primarily assess our interest rate risk by estimating the duration of our assets and the duration of our liabilities. Duration essentially measures the market price volatility of financial instruments as interest rates change. We generally calculate duration using various financial models and empirical data. Different models and methodologies can produce different duration numbers for the same securities.

The following sensitivity analysis table shows the estimated impact on the fair value of our interest rate-sensitive investments and repurchase agreement liabilities at March 31, 2005, assuming rates instantaneously fall 100 basis points, rise 100 basis points and rise 200 basis points:


	Interest Rates					Interest Rates			Interest Rates
	Fall 100					Rise 100			Rise 200
	Basis Points			Unchanged		Basis Points			Basis Points
(in millions)
Adjustable-Rate Mortgage-Backed Securities
Fair value	$	116.1		$	114.5	$	111.8		$	108.3
Change in fair value	$	1.6			—	$	(2.7	)	$	(6.2	)
Change as a percent of fair value		1.4	%		—		(2.4	)%		(5.4	)%

Hybrid Adjustable-Rate Mortgage-Backed Securities
Fair value	$	4,358.5		$	4,285.4	$	4,187.5		$	4,070.0
Change in fair value	$	73.1			—	$	(97.9	)	$	(215.4	)
Change as a percent of fair value		1.7	%		—		(2.3	)%		(5.0	)%

Balloon Mortgage-Backed Securities
Fair value	$	54.1		$	53.2	$	52.1		$	50.8
Change in fair value	$	0.9			—	$	(1.1	)	$	(2.4	)
Change as a percent of fair value		1.7	%		—		(2.1	)%		(4.5	)%

Other Mortgage-Backed Securities
Fair value	$	5.5		$	5.6	$	5.7		$	5.7
Change in fair value		(0.1	)		—		0.1			0.1
Change as a percent of fair value		(1.8	)%		—		1.8	%		1.8	%

Total Mortgage-Backed Securities
Fair value	$	4,534.2		$	4,458.7	$	4,357.1		$	4,234.8
Change in fair value	$	75.5			—	$	(101.6	)	$	(223.9	)
Change as a percent of fair value		1.7	%		—		(2.3	)%		(5.0	)%

Repurchase Agreements ⁽¹⁾
Fair value	$	4,034.9		$	4,034.9	$	4,034.9		$	4,034.9
Change in fair value		—			—		—			—
Change as a percent of fair value		—			—		—			—

Junior Subordinated Notes
Fair value	$	50.0		$	50.0	$	50.0		$	50.0
Change in fair value		—			—		—			—
Change as a percent of fair value		—			—		—			—

Hedge Instruments
Fair value	$	(0.1	)	$	15.4	$	30.7		$	46.0
Change in fair value	$	(15.5	)		—	$	15.3		$	30.6
Change as a percent of fair value	nm				—	nm			nm

(1)

The fair value of the repurchase agreements would not change materially due to the short-term nature of these instruments.

nm = not meaningful

It is important to note that the impact of changing interest rates on fair value can change significantly when interest rates change beyond 100 basis points from current levels. Therefore, the volatility in the fair value of our assets could increase significantly when interest rates change beyond 100 basis points. In addition, other factors impact the fair value of our interest rate-sensitive investments and hedging instruments, such as the shape of the yield curve, market expectations as to future interest rate changes and other market conditions. Accordingly, in the event of changes in actual interest rates, the change in the fair value of our assets would likely differ from that shown above, and such difference might be material and adverse to our stockholders.

Risk Management

To the extent consistent with maintaining our status as a REIT, we seek to manage our interest rate risk exposure to protect our portfolio of mortgage-backed securities and related debt against the effects of major interest rate changes. We generally seek to manage our interest rate risk by:

	•	monitoring and adjusting, if necessary, the reset index and interest rate related to our mortgage-backed securities and our borrowings;

	•	attempting to structure our borrowing agreements to have a range of different maturities, terms, amortizations and interest rate adjustment periods;

	•	using derivatives, financial futures, swaps, options, caps, floors and forward sales to adjust the interest rate sensitivity of our mortgage-backed securities and our borrowings; and

	•	actively managing, on an aggregate basis, the interest rate indices, interest rate adjustment periods and gross reset margins of our mortgage-backed securities and the interest rate indices and adjustment periods of our borrowings.

Item 4. Controls and Procedures.

Conclusion Regarding Disclosure Controls and Procedures

As of March 31, 2005, our principal executive officer and our principal financial officer have performed an evaluation of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934, or Exchange Act) and concluded that our disclosure controls and procedures are effective to ensure that information required to be disclosed by us in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC rules and forms.

Changes in Internal Control Over Financial Reporting

There were no changes in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that occurred during the first quarter of our fiscal year ending December 31, 2005 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II

OTHER INFORMATION

Item 1. Legal Proceedings.

At March 31, 2005, there were no pending legal proceedings to which we were party or of which any of our properties were subject.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

On February 4, 2005, we issued 84,462 shares of our common stock to Seneca Capital Management LLC, in reliance on the exemption from registration provided by Section 4(2) of the Securities Act and Rule 506 thereunder.

Item 3. Defaults Upon Senior Notes.

None.

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

None

Item 5. Other Information.

None.

Item 6. Exhibits.

The exhibits listed on the Exhibit Index (following the Signatures section of this report) are included, or incorporated by reference, in this Quarterly Report on Form 10-Q.

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1394, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.


		LUMINENT MORTGAGE CAPITAL, INC.
		(Registrant)

		By:		/s/ GAIL P. SENECA

				Gail P. Seneca
				Chief Executive Officer
				(Principal Executive Officer)

		Date:		May 10, 2005

		By:		/s/ CHRISTOPHER J. ZYDA

				Christopher J. Zyda
				Chief Financial Officer
				(Principal Financial and Accounting Officer)

		Date:		May 10, 2005

EXHIBIT INDEX

Pursuant to Item 601(a)(2) of Regulation S-K, this exhibit index immediately precedes any exhibits filed herewith.

The following exhibits are included, or incorporated by reference, in this Quarterly Report on Form 10-Q and are numbered in accordance with Item 601 of Regulation S-K.


Exhibit
Number		Description
3.1		Second Articles of Amendment and Restatement (4)

3.2		Second Amended and Restated Bylaws (1)

4.1		Form of Common Stock Certificate (1)

4.2		Registration Rights Agreement, dated as of June 11, 2003, by and between the Registrant and Friedman, Billings, Ramsey & Co., Inc. (for itself and for the benefit of the holders from time to time of registrable securities issued in the Registrant’s June 2003 private offering) (1)

10.1		Amended and Restated Management Agreement, dated as of March 1, 2005, by and between the Registrant and Seneca Capital Management LLC (7)

10.2		Cost-Sharing Agreement, dated as of June 11, 2003, by and between the Registrant and Seneca (1)

10.3†		2003 Stock Incentive Plan (1)

10.4†		Form of Incentive Stock Option under the 2003 Stock Incentive Plan (1)

10.5†		Form of Non Qualified Stock Option under the 2003 Stock Incentive Plan (1)

10.6†		2003 Outside Advisors Stock Incentive Plan of the Registrant (1)

10.7†		Form of Non-Qualified Stock Option under the 2003 Outside Advisors Stock Incentive Plan (1)

10.8†		Form of Indemnity Agreement (1)

10.9†		Employment Agreement dated as of August 4, 2003 by and between the Registrant and Christopher J. Zyda (1)

10.10†		Form of Restricted Stock Award Agreement for Christopher J. Zyda (1)

10.11†		Form of Restricted Stock Award Agreement for Seneca (3)

10.12		Controlled Equity Offering Sales Agreement dated February 7, 2005 between Luminent Mortgage Capital, Inc. and Cantor Fitzgerald & Co. (6)

10.13†		Letter Agreement dated March 8, 2005 between Luminent Mortgage Capital, Inc. and S. Trezevant Moore, Jr. (8)

31.1 *		Certification of Gail P. Seneca, Chairman of the Board of Directors and Chief Executive Officer of the Registrant, pursuant to Rule 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2 *		Certification of Christopher J. Zyda, Chief Financial Officer of the Registrant, pursuant to Rule 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1 *		Certification of Gail P. Seneca, Chairman of the Board of Directors and Chief Executive Officer of the Registrant, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

32.2 *		Certification of Christopher J. Zyda, Chief Financial Officer of the Registrant, 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 to our Registration Statement on Form S-11 (Registration No. 333-107984) which became effective under the Securities Act of 1933, as amended, on December 18, 2003.

(2)		Incorporated by reference to our Current Report on Form 8-K filed on December 23, 2003.

(3)		Incorporated by reference to our Registration Statement on Form S-11 (Registration No. 333-107981), which became effective under the Securities Act of 1933, as amended, on February 13, 2004.

(4)		Incorporated by reference to our Quarterly Report on Form 10-Q for the quarter ended June 30, 2004.

(5)		Incorporated by reference to our registration statement on Form S-11 (Registration No. 333-113493) which became effective under the Securities Act of 1933, as amended, on March 30, 2004.

(6)		Incorporated by reference to our Current Report on Form 8-K filed on February 8, 2005.

(7)		Incorporated by reference to our Current Report on Form 8-K filed on April 1, 2005.

(8)		Incorporated by reference to our Current Report on Form 8-K filed on March 14, 2005.

*		Filed herewith.

†		Denotes a management contract or compensatory plan.