Annaly Capital Management
Annual Report 2002

Plain-text annual report

Annaly Mortgage Management, Inc. Annual Report 2002 Workers on Wall Street Celebrating the End of WWII Jubilant financial district workers swarm the intersection of Wall and Broad, clambering over the statue of George Washington in front of the Sub-Treasury building. 2 4 6 8 9 Corporate Profile Letter from the President The Annaly Team Selected Financial Data Financial Review 10 19 20 21 22 23 24 30 31 Management’s Discussion and Analysis of Financial Condition and Results of Operations Independent Auditors’ Report Statements of Financial Condition Statements of Operations Statements of Stockholders’ Equity Statements of Cash Flows Notes to Financial Statements Common Stock and Market Information Corporate Information Annaly Mortgage Management, Inc. Annual Report 2002 Our family crest and its motto “Prodesse non Nocere” are the trademarks of the Company. The description figuratively means ‘Proceed without fear.’ That symbolizes the confidence we try to instill in our investors. It is reinforced by years of reliable, consistent investment performance. Annaly Mortgage Management, Inc. T he year 2002 demonstrated Annaly’s ability to generate consistent returns for shareholders. Our proven model of investing in liquid, high quality assets and accessing the capital markets through sequential, accretive stock offerings resulted in a year of record earnings and dividends. Stockholders’ Equity (dollars in thousands) 2000 2001 2002 $135,642 $667,357 $1,080,066 Earnings Per Share 2000 2001 2002 $1.18 $2.23 $2.68 1 Corporate Profile 2 A nnaly Mortgage Management, Inc. owns and manages a portfolio of mortgage-backed securities. Our principal business objective is to generate net income for distribution to our stockholders from the spread between the interest income on our mortgage-backed securities and the costs of borrowing to finance them. We have elected to be taxed as a real estate investment trust (or REIT) under the Internal Revenue Code. We commenced operations on February 18, 1997. We are self-advised and self-managed. Michael A. J. Farrell Wellington Denahan Kathryn Fagan Jennifer Stephens Chairman, President & CEO Vice Chairman & Chief Investment Officer Chief Financial Officer & Treasurer Executive VP & Corporate Secretary Victory Gardens Everyone on the home front was encouraged to do their part to ease wartime economic hardships through simple, symbolic and patriotic messages. The call to plant a Victory Garden was answered by nearly 20 million Americans. 3 4 Michael A. J. Farrell To Our Fellow Shareholders A s we mark the end of another successful year, I think about the world of difference that exists from just two years ago. Looking back now, the United States was somewhat naïve about its vulnerability in the world, as well as the future prospects for globalization and the conflicts it would create. In many ways we were not unlike the U.S. in the late 1930s. A year has passed since last year’s annual meeting, and upon reflection I am struck by the contrast from other annual meetings. At the close of last year’s annual meeting, a stately “greatest gener- ation” veteran stood up at the last call for questions and nominat- ed the entire Annaly management team for the “Distinguished Service Cross” for meritorious service. This gentleman, a retired officer of World War II who served under General Patton and a veteran of the “financial services wars” for the past 50 years, spoke eloquently of the discipline he noticed in our management style, our execution and our dedication to providing strong shareholder value through extremely difficult markets. As he spoke, it occurred to me that while it is easy for us to get caught up in the day-to-day battles in the commercial marketplace, we should stop to consider the lesson of this man who, in his eighties now, had a spark and appreciation for life derived from the uniquely broad experience of his generation. I took his remarks back to the team that day, but his mark was left on me. During the course of the year we meet or speak with liter- ally thousands of investors, and I like to think that we earn the respect of investors one at a time. This Annaly shareholder, Colonel Julian Risken, has a great deal to teach us all. I met with him for lunch a couple of times after the annual meeting—mostly because the “greatest generation” holds a special place in my heart—and here’s what I learned from him: Appreciate what you have and live life to the fullest, regardless of the present hurdles. He recently retired from a large financial services firm after many years. Upon retiring, his first phone call was to the police com- missioner of New York City to offer his services for the “home guard,” to help protect the country from “those scoundrels” who would do harm to his beloved country and city. I don’t think that we will see the Colonel watching daytime television from the front porch. After the terrible tragedy experienced on September 11, 2001, this man, in my mind, exemplifies the American spirit. His zeal and determination to take personal responsibility for making the world a better place clearly affect everything from his demeanor to his view of life. The theme of this year’s annual report is the celebration that was felt at the end of the Second World War. It is appropriate that we under- stand the relief that is expressed in the faces from the past. It is also important to listen to the voices of those who did their part, experi- enced so much in their lives and taught perspective to all of us. In today’s world there are many challenges. The political front has us involved in an ideological war with roots dating back over 20 years; this war will not end with a celebration in Times Square or with a signed declaration of peace on the deck of an aircraft carrier. The economic front is mired in cleaning up the excesses created in the late 1990s when everyone was “rich” and going to retire early, perhaps to the front porch that Colonel Risken eschewed. We believe we have carefully positioned the company to meet the expected and the unexpected global, political and eco- nomic challenges going forward. There is no doubt in my mind that America—and our company—will overcome and survive the many challenges it faces. When I walk into the office each day I feel the same energy that Colonel Risken exudes. It is a testament to the women and men that represent Annaly in its daily business affairs that our business model is as successful as it is. While many may question the resolve of today’s Americans, I don’t. We are a resourceful people, with a wonderful blend of diversity and heritage inside of us, unlike any other in history. Individuals like the Colonel remind me of it continually. The highlights of 2002 will reflect record earnings of $2.68 per share, a doubling in market capitalization to $1.6 billion, the entry of the company into the Russell 1000 index and avoidance of many of the pitfalls that plague our competitors in the sector. As regards Annaly, it is the ongoing relationship with investors that binds our commitment to the diligent pursuit of a sound business strategy. We work hard every day to fulfill this commit- ment, one shareholder at a time. Against the background of turbulence, terrorism, corporate governance issues, volatile interest rates and economic uncertainty,the NLY team deserved the symbolism of the Distinguished Service Medal offered by Colonel Risken. Yes, America may have been naïve and distracted two years ago or 60 years ago, but it is not now. As evidenced by 2002’s results, neither is the NLY team. March 17, 2003 5 6 The Annaly Team A nnaly’s team is experienced in Wall Street trading, manage- ment and operations, with a specialization in investing in mortgage-backed securities on a leveraged basis. Senior management founded and capitalized Annaly Mortgage Management in November 1996. Successfully completing a private placement in February 1997, an IPO in October 1997 and four secondary offerings from January 2001 through January 2002, Annaly has consistently generated double-digit returns for its share- holders. Annaly Mortgage Management’s success and future growth prospects are based on the proven ability of its strong and seasoned management team to deliver excellent results in volatile markets. The Annaly team Left to right, seated: Wellington Denahan, Jennifer Stephens, Kathryn Fagan, Michael Farrell. Standing: Nancy Murtha, Annie Montoya, Isabel Gordillo, Konstantin Pavlov, Rose-Marie Lyght, Ronald Kazel, Alexandra Denahan, Jeremy Diamond, Martha Cobo, James Fortescue. Rosie The Riveter Helping to win the war were the 6 million women who worked at indus- trial jobs, ensuring American productivity and challenging traditional notions of women’s capabilities. The sight of women outfitted in over- alls and wielding industrial tools became an icon that was popularized in the 1942 song, “Rosie the Riveter,” providing a nickname for all women who worked in wartime industries. “All the day long, whether rain or shine/ She’s a part of the assembly line./ She’s making history, working for victory/ Rosie the Riveter.” 7 8 Selected Financial Data Annaly Mortgage Management, Inc. (dollars in thousands, except for per share data) For the Year Ended December 31, 2002 For the Year Ended December 31, 2001 For the Year Ended December 31, 2000 For the Year Ended December 31, 1999 For the Year Ended December 31, 1998 Statement of Operations Data: Interest income Interest expense Net interest income Gain on sale of mortgage-backed securities General and administrative expenses (G&A expense) Net income Basic net income per average share Diluted net income per average share Dividends declared per share Balance Sheet Data: Mortgage-Backed Securities, net Total assets Repurchase agreements Total liabilities Stockholders’ equity Number of common shares outstanding Other Data: Average total assets Average earning assets Average borrowings Average equity Yield on interest earning assets Cost of funds on interest bearing liabilities Interest rate spread Annualized Financial Ratios: Net interest margin (net interest income/average total assets) G&A expense as a percentage of average assets G&A expense as a percentage of average equity Return on average assets Return on average equity $ 404,165 191,758 $ 212,407 21,063 13,963 $ 219,507 $ $ $ 2.68 2.67 2.67 $11,551,857 11,659,084 10,163,174 10,579,018 1,080,066 84,569,206 $10,486,423 9,575,365 9,128,933 978,107 4.22% 2.10% 2.12% 2.03% 0.13% 1.43% 2.09% 22.44% $ $ $ $ $ $ 263,058 168,055 95,003 4,586 7,311 92,278 2.23 2.21 1.75 $ $ $ $ $ $ 109,750 92,902 16,848 2,025 2,286 16,587 1.18 1.15 1.15 $ $ $ $ $ $ 89,812 69,846 19,966 454 2,281 18,139 1.41 1.35 1.38 $ $ $ $ $ $ 89,986 75,735 14,251 3,344 2,106 15,489 1.22 1.19 1.21 $ 7,575,379 $ 1,978,219 $ 1,437,793 $ 1,520,289 7,717,314 6,367,710 7,049,957 667,357 59,826,975 2,035,029 1,628,359 1,899,386 135,642 14,522,978 1,491,322 1,338,296 1,388,050 103,272 1,527,352 1,280,510 1,401,481 125,871 13,581,316 12,648,424 $ 5,082,852 $ 1,652,459 $ 1,473,765 $ 1,499,875 4,682,780 4,388,900 437,376 5.62% 3.83% 1.79% 1.87% 0.14% 1.67% 1.82% 21.10% 1,564,491 1,449,999 117,727 7.02% 6.41% 0.61% 1.02% 0.14% 1.94% 1.00% 14.09% 1,461,254 1,350,230 117,685 6.15% 5.17% 0.98% 1.35% 0.15% 1.94% 1.23% 15.41% 1,461,791 1,360,040 131,265 6.16% 5.57% 0.59% 0.95% 0.14% 1.60% 1.03% 11.80% Financial Review Annaly Mortgage Management, Inc. Annaly Mortgage Management, Inc. 9 Management’s Discussion and Analysis of Financial Condition and Results of Operations Independent Auditors’ Report Statements of Financial Condition Statements of Operations Statements of Stockholders’ Equity Statements of Cash Flows Notes to Financial Statements Common Stock and Market Information Corporate Information 10 19 20 21 22 23 24 30 31 10 Management’s Discussion and Analysis of Financial Condition and Results of Operations Annaly Mortgage Management, Inc. Overview W e are a real estate investment trust that owns and manages a portfolio of mortgage-backed securities. Our principal business objective is to generate net income for distribution to our stockholders from the spread between the interest income on our mortgage-backed securities and the costs of borrowing to finance our acquisition of mortgage-backed securities. Special Note Regarding Forward-Looking Statements Certain statements contained in this annual report, and certain statements contained in our future filings with the Securities and Exchange Commission (the “SEC” or the “Commission”), in our press releases or in our other public or shareholder communications may not be, based on historical facts and are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements which are based on various assumptions, (some of which are beyond our control) may be identified by reference to a future period or periods, or by the use of forward-looking terminology, such as “may,” “will,” “believe,” “expect,” “anticipate,” “continue,” or similar terms or variations on those terms, or the negative of those terms. Actual results could dif- fer materially from those set forth in forward-looking statements due to a variety of factors, includ- ing, but not limited to, changes in interest rates, changes in yield curve, changes in prepayment rates, the availability of mortgage backed securities for purchase, the availability of financing and, if available, the terms of any financing. For a discussion of the risks and uncertainties that could cause actual results to differ from those contained in the forward-looking statements, see “Risk Factors.” We do not undertake, and specifically disclaim any obligation, to publicly release the result of any revisions that may be made to any forward-looking statements to reflect the occurrence of antici- pated or unanticipated events or circumstances after the date of such statements. Critical Accounting Policies Management’s discussion and analysis of financial condition and results of operations is based on the amounts reported in our financial statements. These financial statements are prepared in accor- dance with accounting principles generally accepted in the United States of America. In preparing the financial statements, management is required to make various judgments, estimates and assumptions that affect the reported amounts. Changes in these estimates and assumptions could have a material effect on our financial statements. The following is a summary of our policies that is the most affected by management’s judgments, estimates and assumptions. Results of Operations Net Income Summary For the year ended December 31, 2002, our net income was $219.5 million or $2.68 basic earn- ings per average share, as compared to $92.3 million or $2.23 basic earnings per average share for the year ended December 31, 2001. For the year ended December 31, 2000, our net income was $16.6 million, or $1.18 basic earnings per average share. Net income per average share increased by $0.45 and total net income increased by $127.2 million. The increase in 2002 net income over 2001 is attributable to our acquisition of additional mortgage-backed securities using proceeds raised from our January 2002 public offering and Equity Shelf Program during the year and the increase in the interest rate spread between our interest-earning assets and our interest- bearing liabilities. The same is true for the increase in net income for the year 2001, when com- pared to the year 2000. We consummated three public offerings in the year 2001 and the interest rate spread increased. We compute our net income per share by dividing net income by the weighted Market Valuation of Securities: All assets classified as available-for-sale are reported at fair value, based on market prices. Our policy is to obtain market values from three independent sources and record the market value of the securities based on the average of the three. Amortization of premiums and accretion of discounts: Premiums and discounts associated with the purchase of the Mortgage-Backed Securities are amortized into interest income over the lives of the securities using the interest method. Our policy for estimating prepayment speeds for calculating the effective yield is to evaluate historical performance, street consensus prepayment speeds, and cur- rent market conditions. average number of shares of outstanding common stock during the period, which was 82,044,141 for the year ended December 31, 2002, 41,439,631 for the year ended December 31, 2001, and 14,089,436 for the year ended December 31, 2000. Dividends per share for the year ended December 31, 2002 were $2.67, or an aggregate of $223.6 million. Dividends per share for the year ended December 31, 2001 were $1.75 per share, or $88.4 million in total. Dividends per share for the year ended December 31, 2000 were $1.15 per share, or $16.3 million in total. Our return on average equity was 22.44% for the year ended December 31, 2002, 21.10% for the year ended December 31, 2001, and 14.09% for the year ended December 31, 2000. The increase in return on equity in 2002 compared to 2001 is primarily due to the favorable interest rate environment. The table on the following page presents the net income summary for the years ended December 31, 2002, 2001, 2000, 1999, and 1998. Management’s Discussion and Analysis of Financial Condition and Results of Operations Annaly Mortgage Management, Inc. 11 Net Income Summary (dollars in thousands, except for per share data) Interest Income Interest Expense Net Interest Income Gain on Sale of Mortgage-Backed Securities General and Administrative Expenses Year Ended December 31, 2002 Year Ended December 31, 2001 Year Ended December 31, 2000 Year Ended December 31, 1999 Year Ended December 31, 1998 $ 404,165 191,758 $ 212,407 21,063 13,963 $ 263,058 168,055 $ 95,003 4,586 7,311 $ 109,750 $ 92,902 16,802 2,025 2,286 $ $ 89,812 69,846 19,966 454 2,281 $ $ 89,986 75,735 14,251 3,344 2,106 Net Income $ 219,507 $ 92,278 $ 16,587 $ 18,139 $ 15,489 Average Number of Basic Shares Outstanding Average Number of Diluted Shares Outstanding Basic Net Income Per Share Diluted Net Income Per Share Average Total Assets Average Equity Annualized Return on Average Assets Annualized Return on Average Equity 82,044,141 82,282,883 $ $ 2.68 2.67 $10,486,423 978,107 1.43% 22.44% 41,439,631 41,857,498 $ $ 2.23 2.21 $ 5,082,852 437,376 1.82% 21.10% 14,089,436 14,377,459 $ $ 1.18 1.15 $ 1,652,459 117,727 1.00% 14.09% 12,889,510 13,454,007 $ $ 1.41 1.35 $ 1,473,765 117,685 1.23% 15.41% 12,709,116 13,020,648 $ $ 1.22 1.19 $ 1,499,875 131,265 1.03% 11.80% Interest Income and Average Earning Asset Yield We had average earning assets of $9.6 billion for the year ended December 31, 2002. We had aver- age earning assets of $4.7 billion for the year ended December 31, 2001. We had average earning assets of $1.6 billion for the year ended December 31, 2000. Our primary source of income for the years ended December 31, 2002, 2001, and 2000 was interest income. A portion of our income was generated by gains on the sales of our mortgage-backed securities. Our interest income was $404.2 million for the year ended December 31, 2002, $263.1 million for the year ended December 31, 2001, and $109.8 million for the year ended December 31, 2000. Our yield on average earn- ing assets was 4.22%, 5.62%, and 7.02% for the same respective periods. Our yield on average earning assets decreased by 1.40% and our average earning asset balance increased by $4.9 bil- lion for the year ended December 31, 2002, when compared to the prior year. Due to the increase in the asset base resulting from the inflow of capital from our public offering and Equity Shelf Program during the year ended December 31, 2002, interest income increased by $141.1 million. Our yield on average earning assets decreased by 1.40% and our average earning asset balance increased by $3.1 billion for the year ended December 31, 2001, when compared to the prior year. Due to the increase in assets resulting from the three public offerings during the year ended December 31, 2001, interest income increased by $153.3 million. The table below shows our aver- age balance of cash equivalents and mortgage-backed securities, the yields we earned on each type of earning assets, our yield on average earning assets and our interest income for the years ended December 31, 2002, 2001, 2000, and 1999, and 1998 the four quarters in 2002. Average Earning Asset Yield (dollars in thousands) For the Year Ended December 31, 2002 For the Year Ended December 31, 2001 For the Year Ended December 31, 2000 For the Year Ended December 31, 1999 For the Year Ended December 31, 1998 For the Quarter Ended December 31, 2002 For the Quarter Ended September 30, 2002 For the Quarter Ended June 30, 2002 For the Quarter Ended March 31, 2002 (ratios for the four quarters in 2002 are annualized) Average Cash Equivalents $ 2 $ 2 $263 $221 $ 2 $ 2 $ 2 $ 2 $ 2 Average Mortgage- Backed Securities Average Earning Assets $ 9,575,365 $ 9,575,367 $ 4,682,778 $ 1,564,228 $ 1,461,033 $ 1,461,789 $10,400,894 $10,661,228 $ 9,629,332 $ 7,610,006 $ 4,682,780 $ 1,564,491 $ 1,461,254 $ 1,461,791 $10,400,896 $10,661,230 $ 9,629,334 $ 7,610,008 Yield on Average Cash Equivalents 1.14% 3.25% 4.18% 4.10% 4.32% 0.88% 1.14% 1.23% 1.29% Yield on Average Mortgage- Backed Securities 4.22% 5.62% 7.02% 6.15% 6.16% 3.56% 4.10% 4.55% 4.88% Yield on Average Earning Assets 4.22% 5.62% 7.02% 6.15% 6.16% 3.56% 4.10% 4.55% 4.88% Interest Income $404,165 $263,058 $109,750 $ 89,812 $ 89,986 $ 92,641 $109,201 $109,423 $ 92,900 The constant prepayment rate (“CPR”) on our mortgage-backed securities for the year ended December 31, 2002 was 33%, for the year ended December 31, 2001 was 26%, and for the year ended December 31, 2000 was 11%. CPR is an assumed rate of prepayment for our mortgage- backed securities, expressed as an annual rate of prepayment relative to the outstanding principal balance of our mortgage-backed securities. CPR does not purport to be either a historical descrip- tion of the prepayment experience of our mortgage-backed securities or a prediction of the antici- pated rate of prepayment of our mortgage-backed securities. Principal prepayments had a negative effect on our earning asset yield for the years ended December 31, 2002, 2001, and 2000 because we adjust our rates of premium amortization and discount accretion monthly based upon the effective yield method, which takes into consideration changes in prepayment speeds. 12 Management’s Discussion and Analysis of Financial Condition and Results of Operations Annaly Mortgage Management, Inc. Interest Expense and the Cost of Funds Our largest expense is the cost of borrowed funds, primarily through repurchase agreements. We had average borrowed funds of $9.1 billion for the year ended December 31, 2002, $4.4 billion for the year ended December 31, 2001, and $1.4 billion for the year ended December 31, 2000. Interest expense totaled $191.8 million, $168.1 million, and $92.9 million for the years ended December 31, 2002, 2001, and 2000, respectively. Our average cost of funds was 2.10% for the year ended December 31, 2002, 3.83% for the year ended December 31, 2001, and 6.41% for the year ended December 31, 2000. The cost of funds rate decreased by 1.73% and the average borrowed funds increased by $4.7 billion for the year ended December 31, 2002. Interest expense for the year ended December 31, 2002 increased $23.7 million, from $168.1 million to $191.8 million. We increased our asset base by raising approximately $379.5 million of additional capital in 2002. As a result, we increased the amounts borrowed under repurchase agreements. Consequently, the increased inter- est expense for the year 2002 is the result of our growth. The cost of funds rate decreased by 2.58% and the average borrowed funds increased by $3.0 billion for the year ended December 31, 2001. Interest expense for the year ended December 31, 2001 increased $75.2 million. We increased our asset base by raising approximately $474.2 million of additional capital in 2001. Consequently, the increased interest expense for the year 2001 is the result of our growth. Average Cost of Funds (dollars in thousands) Average Borrowed Funds Interest Expense For the Year Ended December 31, 2002 $ 9,128,933 $191,758 For the Year Ended December 31, 2001 $ 4,388,900 $168,055 For the Year Ended December 31, 2000 $ 1,449,999 $ 92,902 For the Year Ended December 31, 1999 $ 1,350,230 $ 69,846 For the Year Ended December 31, 1998 For the Quarter Ended December 31, 2002 $ 1,360,040 $ 10,097,676 $ 75,735 $ 49,874 For the Quarter Ended September 30, 2002 $10,122,840 $ 54,012 For the Quarter Ended June 30, 2002 $ 9,102,992 $ 47,860 For the Quarter Ended March 31, 2002 $ 7,192,222 $ 40,012 (Ratios for the four quarters in 2002 have been annualized) Changes in our short-term cost of funds are expected to be closely correlated with changes in short- term LIBOR, although we have chosen to extend the maturity on a portion of our liabilities to three years. Our average cost of funds was 0.33% greater than average one-month LIBOR for the year ended December 31, 2002, and 0.22% greater than average six-month LIBOR. Our average cost of funds was 0.05% less than average one-month LIBOR for the year ended December 31, 2001, and 0.10% greater than average six-month LIBOR. Our average cost of funds was equal to average one- month LIBOR for the year ended December 31, 2000, and 0.25% less than average six-month LIBOR. During the year ended December 31, 2002, average one-month LIBOR, which was 1.77%, was 0.11% less than average six-month LIBOR, which was 1.88%. During the year ended December 31, 2001, average one-month LIBOR, which was 3.88%, was 0.15% greater than average six-month LIBOR, which was 3.73%. During the year ended December 31, 2000, average one-month LIBOR, which was 6.41%, was 0.25% lower than average six-month LIBOR, which was 6.66%. The table below shows our average borrowed funds and average cost of funds as compared to average one- month and average six-month LIBOR for the years ended December 31, 2002, 2001, 2000, 1999, 1998, and the four quarters in 2002. Average Cost of Funds 2.10% 3.83% 6.41% 5.17% 5.57% 1.98% 2.13% 2.10% 2.23% Average One- Month LIBOR 1.77% 3.88% 6.41% 5.25% 5.57% 1.57% 1.82% 1.85% 1.85% Average One- Month LIBOR Relative to Average Six- Month LIBOR (0.11%) 0.15% (0.25%) (0.28%) 0.03% 0.02% — (0.26%) (0.21%) Average Cost of Funds Relative to Average One- Month LIBOR 0.33% (0.05%) — (0.08%) — 0.41% 0.31% 0.25% 0.38% Average Cost of Funds Relative to Average Six- Month LIBOR 0.22% 0.10% (0.25%) (0.36%) 0.03% 0.43% 0.31% (0.01%) 0.17% Average Six-Month LIBOR 1.88% 3.73% 6.66% 5.53% 5.54% 1.55% 1.82% 2.11% 2.06% Net Interest Income Our net interest income, which equals interest income less interest expense, totaled $212.4 million for the year ended December 31, 2002, $95.0 million for the year ended December 31, 2001, $16.8 million for the year ended December 31, 2000. Our net interest spread, which equals the yield on our average assets for the period less the average cost of funds for the period, was 2.12% for the year ended December 31, 2002, which is a 0.33% increase over the prior year. The net interest spread for the year ended December 31, 2001 was 1.79%, as compared to 0.61% for the year ended December 31, 2000. Our net interest income increased by $117.4 million for the year ended December 31, 2002 over the prior year. The increase in our balance sheet which resulted from our raising addi- tional capital in 2002, along with the 0.33% increase in the interest rate spread. The substantial increase in our balance sheet in 2001 which resulted from our raising additional capital in that year, along with the 1.18% increase in the interest rate spread, caused the $78.2 million increase in net interest income. Net interest margin, which equals net interest income divided by average interest earning assets, was 2.03% for the year ended December 31, 2002, 1.87% for the year ended December 31, 2001, and 1.02% for the year ended December 31, 2000. The principal reason that net interest margin exceeded net interest spread is that average interest earning assets exceeded average interest bearing liabilities. A portion of our assets is funded with equity rather than borrowings. The table on the following page shows our interest income by earning asset type, average earning assets by type, total interest income, interest expense, average repurchase agreements, average cost of funds, and net interest income for the years ended December 31, 2002, 2001, 2000, 1999, 1998, and the four quarters in 2002. Management’s Discussion and Analysis of Financial Condition and Results of Operations Annaly Mortgage Management, Inc. 13 Net Interest Income For the Year Ended Average Mortgage- Backed Securities Held Interest Income on Mortgage- Backed Securities Average Cash Equivalents Total Interest Income Yield on Average Interest Earning Assets Average Balance of Repurchase Agreements Interest Expense Average Cost of Funds Net Interest Income December 31, 2002 $ 9,575,365 $404,165 $ 2 $404,165 4.22% $ 9,128,933 $191,758 2.10% $212,407 For the Year Ended December 31, 2001 $ 4,682,778 $263,058 $ 2 $263,058 5.62% $ 4,388,900 $168,055 3.83% $ 95,003 For the Year Ended December 31, 2000 $ 1,564,228 $109,739 $263 $109,750 7.02% $ 1,449,999 $ 92,902 6.41% $ 16,848 For the Year Ended December 31, 1999 $ 1,461,033 $ 89,801 $221 $ 89,812 6.15% $ 1,350,230 $ 69,846 5.17% $ 19,966 For the Year Ended December 31, 1998 For the Quarter Ended December 31, 2002 For the Quarter Ended September 30, 2002 For the Quarter Ended $ 1,461,789 $ 89,986 $ 2 $ 89,986 6.16% $ 1,360,040 $ 75,735 5.57% $ 14,251 $10,400,894 $ 92,641 $ 2 $ 92,641 3.56% $ 10,097,676 $ 49,874 1.98% $ 42,767 $10,661,228 $109,201 $ 2 $109,201 4.10% $10,122,840 $ 54,012 2.13% $ 55,189 June 30, 2002 $ 9,629,332 $109,423 $ 2 $109,423 4.55% $ 9,102,992 $ 47,860 2.10% $ 61,563 For the Quarter Ended March 31, 2002 $ 7,610,006 $ 92,900 $ 2 $ 92,900 4.88% $ 7,192,222 $ 40,012 2.23% $ 52,888 (Ratios for the four quarters in 2002 have been annualized) Gains and Losses on Sales of Mortgage-Backed Securities For the year ended December 31, 2002, we sold mortgage-backed securities with an aggregate historical amortized cost of $2.1 billion for an aggregate gain of $21.1 million. For the year ended December 31, 2001, we sold mortgage-backed securities with an aggregate historical amortized cost of $1.2 billion for an aggregate gain of $4.6 million. For the year ended December 31, 2000, we sold mortgage-backed securities with an aggregate historical amortized cost of $487.8 million for an aggregate gain of $2.0 million. The gain on sale of assets for the year ended December 31, 2002 increased by $16.5 million over the prior year. We were able to take advantage to the appre- ciation in our portfolio, while maintaining a book value of $12.77. The gain on sale of assets for the year ended December 31, 2001 increased by $2.6 million over the prior year. Even though the gain for the year 2001 increased over the prior year, as a percentage of total income it declined. We do not expect to sell assets on a frequent basis, but may from time to time sell existing assets to move into new assets, which our management believes might have higher risk-adjusted returns, or to manage our balance sheet as part of our asset/liability management strategy. Credit Losses We have not experienced credit losses on our mortgage-backed securities to date. We have limited our exposure to credit losses on our mortgage-backed securities by purchasing only securities, issued or guaranteed by Federal Home Loan Mortgage Corporation, the Federal National Mortgage Association, or the Government National Mortgage Association, which, although not rated, carry an implied “AAA” rating. Under our capital investment policy, however, up to 25% of our securities could be rated “BBB” or better or if unrated, securities we deem to be of a quality “BBB” or better. General and Administrative Expenses General and administrative expenses (“G&A”) were $14.0 million for the year ended December 31, 2002, $7.3 million for the year ended December 31, 2001, and $2.3 million for the year ended December 31, 2000. G&A expenses as a percentage of average assets was 0.13%, 0.14%, and 0.14% for the years ended December 31, 2002, 2001, and 2000, respectively. G&A expense has increased proportionately with our increased capital base. Increases in salaries were the primary reason for the overall increase in G&A. In 2002, we paid aggregate salaries and bonuses of $10.8 million compared to $4.7 million in 2001. The staff increased to 15 employees by the end of 2002 from 10 employees at the end of 2001. G&A expenses in total were materially unchanged for the years ended December 31, 2001, and 2000. The table on the following page shows our total G&A expenses as compared to average assets and average equity for the years ended December 31, 2002, 2001, 2000, 1999, 1998, and the four quarters in 2002. 14 Management’s Discussion and Analysis of Financial Condition and Results of Operations Annaly Mortgage Management, Inc. G&A Expenses and Operating Expense Ratios (dollars in thousands) For the Year Ended December 31, 2002 For the Year Ended December 31, 2001 For the Year Ended December 31, 2000 For the Year Ended December 31, 1999 For the Year Ended December 31, 1998 For the Quarter Ended December 31, 2002 For the Quarter Ended September 30, 2002 For the Quarter Ended June 30, 2002 For the Quarter Ended March 31, 2002 (Ratios for the four quarters in 2002 have been annualized) Total G&A Expenses $13,963 $ 7,311 $ 2,286 $ 2,281 $ 2,106 $ 3,904 $ 3,268 $ 3,536 $ 3,255 Total G&A Expenses/Average Assets Total G&A Expenses/Average Equity 0.13% 0.14% 0.14% 0.15% 0.14% 0.13% 0.12% 0.13% 0.14% 1.43% 1.67% 1.94% 1.94% 1.60% 1.44% 1.22% 1.37% 1.55% Net Income and Return on Average Equity Our net income was $219.5 million for the year ended December 31, 2002, $92.3 million for the year ended December 31, 2001, and $16.6 million for the year ended December 31, 2000. Our return on average equity was 22.44% for the year ended December 31, 2002, 21.1% for the year ended December 31, 2001, and 14.1% for the year ended December 31, 2000. Net income increased by $127.2 million in the year 2002 over the previous year, due to the increased asset base and the increase in the average interest rate spread. The increase in net income for the year ended December 2001, as compared to the year ended December 31, 2000, is a direct result of growth in our balance sheet following our three public offerings in 2001, as well as the favorable interest rate environment during the year 2001. We were able to take advantage of appreciation in asset value in 2001. The gain on sale of securi- ties increased by $2.6 million for the year ended December 31, 2001, as compared to the prior year. The table below shows our net interest income, gain on sale of mortgage-backed securities and G&A expenses each as a percentage of average equity, and the return on average equity for the years ended December 31, 2002, 2001, 2000, 1999, and 1998, and for the four quarters in 2002. Components of Return on Average Equity For the Year Ended December 31, 2002 For the Year Ended December 31, 2001 For the Year Ended December 31, 2000 For the Year Ended December 31, 1999 For the Year Ended December 31, 1998 For the Quarter Ended December 31, 2002 For the Quarter Ended September 30, 2002 For the Quarter Ended June 30, 2002 For the Quarter Ended March 31, 2002 (Ratios for the four quarters in 2002 have been annualized) Financial Condition Net Interest Income/Average Equity Gain on Sale of Mortgage-Backed Equity G&A Expenses/Average Equity 21.72% 21.72% 14.31% 16.97% 10.85% 15.80% 20.68% 23.93% 25.24% 2.15% 1.05% 1.72% 0.38% 2.55% 4.27% 1.78% 0.52% 1.63% 1.43% 1.67% 1.94% 1.94% 1.60% 1.44% 1.22% 1.37% 1.55% Return on Average Equity 22.44% 21.10% 14.09% 15.41% 11.80% 18.63% 21.24% 23.08% 25.32% Mortgage-Backed Securities All of our mortgage-backed securities at December 31, 2002, 2001, and 2000 were adjustable-rate or fixed-rate mortgage-backed securities backed by single-family mortgage loans. All of the mort- gage assets underlying these mortgage-backed securities were secured with a first lien position on the underlying single-family properties. All our mortgage-backed securities were FHLMC, FNMA or GNMA mortgage pass-through certificates or CMOs, which carry an implied “AAA” rating. We mark- to-market all of our earning assets at liquidation value. We accrete discount balances as an increase in interest income over the life of discount mortgage- backed securities and we amortize premium balances as a decrease in interest income over the life of premium mortgage-backed securities. At December 31, 2002, 2001, and 2000, we had on our balance sheet a total of $664,000, $2.1 million, and $989,000, respectively, of unamortized dis- count (which is the difference between the remaining principal value and current historical amor- tized cost of our mortgage-backed securities acquired at a price below principal value) and a total of $274.6 million, $139.4 million, and $24.3 million, respectively, of unamortized premium (which is the difference between the remaining principal value and the current historical amortized cost of our mortgage-backed securities acquired at a price above principal value). We received mortgage principal repayments of $4.7 billion for the year ended December 31, 2002, $1.7 billion for the year ended December 31, 2001, and $168.5 million for the year ended December 31, 2000. The overall prepayment speed for the year ended December 31, 2002, 2001, 2000 was 33%, 27%, and 11%, respectively. During the quarter ended December 31, 2002, the prepayment speeds were the highest in our history at 43%. The result was record returns of principal for the year, relative to the asset size. The increase in prepayments in 2001 from 2000 was primarily Management’s Discussion and Analysis of Financial Condition and Results of Operations Annaly Mortgage Management, Inc. 15 because we acquired more mortgage-backed securities following our three public offerings. Given our current portfolio composition, if mortgage principal prepayment rates were to increase over the life of our mortgage-backed securities, all other factors being equal, our net interest income would decrease during the life of these mortgage-backed securities as we would be required to amortize our net premium balance into income over a shorter time period. Similarly, if mortgage principal pre- payment rates were to decrease over the life of our mortgage-backed securities, all other factors being equal, our net interest income would increase during the life of these mortgage-backed secu- rities as we would amortize our net premium balance over a longer time period. The table below summarizes certain characteristics of our mortgage-backed securities at December 31, 2002, 2001, 2000, 1999, and 1998, September 30, 2002, June 30, 2002, and March 31, 2002. Mortgage-Backed Securities (dollars in thousands) At December 31, 2002 At December 31, 2001 At December 31, 2000 At December 31, 1999 At December 31, 1998 At September 30, 2002 At June 30, 2002 At March 31, 2002 Principal Value $11,202,384 $ 7,399,941 $ 1,967,967 $ 1,452,917 $ 1,502,414 $ 11,170,379 $10,833,374 $ 9,982,678 Net Premium $273,963 $137,269 $ 23,296 $ 22,444 $ 24,278 $ 244,777 $224,114 $193,048 Amortized Cost Amortized Cost/Principal Value Estimated Fair Value $11,476,347 102.45% $11,551,857 $ 7,537,210 $ 1,991,263 $ 1,475,361 $ 1,526,692 $11,415,156 $ 11,057,488 $ 10,175,726 101.86% 101.18% 101.54% 101.62% 102.19% 102.07% 101.93% $ 7,575,379 $ 1,978,219 $ 1,437,793 $ 1,520,289 $11,489,538 $ 11,124,771 $10,206,228 Estimated Fair Value/Principal Value 103.12% 102.37% 100.52% 98.96% 101.19% 102.86% 102.69% 102.24% Weighted Average Yield 3.25% 4.41% 7.09% 6.77% 6.43% 3.67% 3.90% 4.31% The tables below set forth certain characteristics of our mortgage-backed securities. The index level for adjustable-rate mortgage-backed securities is the weighted average rate of the various short-term interest rate indices, which determine the coupon rate. Adjustable-Rate Mortgage-Backed Security Characteristics (dollars in thousands) At December 31, 2002 At December 31, 2001 At December 31, 2000 At December 31, 1999 At December 31, 1998 At September 30, 2002 At June 30, 2002 At March 31, 2002 Principal Value $ 7,007,062 $5,793,250 $1,454,356 $ 951,839 $1,030,654 $ 7,583,147 $ 7,939,126 $ 7,248,832 Weighted Average Coupon Rate 4.10% 5.90% 7.61% 7.33% 6.84% 4.37% 4.57% 4.94% Weighted Average Index Level Weighted Average Net Margin 2.51% 3.95% 5.76% 5.84% 5.18% 2.80% 2.96% 3.25% 1.59% 1.95% 1.85% 1.49% 1.66% 1.57% 1.61% 1.69% Weighted Average Term to Next Adjustment 11 months 24 months 15 months 11 months 12 months 10 months 12 months 16 months Weighted Average Lifetime Cap 10.37% 11.49% 11.47% 10.30% 10.63% 10.36% 10.46% 10.73% Weighted Average Asset Yield 2.33% 3.87% 7.24% 7.64% 6.42% 2.90% 3.17% 3.52% Fixed-Rate Mortgage-Backed Security Characteristics (dollars in thousands) At December 31, 2002 At December 31, 2001 At December 31, 2000 At December 31, 1999 At December 31, 1998 At September 30, 2002 At June 30, 2002 At March 31, 2002 Principal Value $4,195,322 $1,606,691 $513,611 $501,078 $471,760 $3,587,232 $2,894,248 $2,733,846 Weighted Average Coupon Rate 6.76% 6.92% 6.62% 6.58% 6.55% 6.95% 7.09% 7.01% Weighted Average Asset Yield 4.78% 6.33% 6.68% 7.01% 6.47% 5.29% 5.91% 6.40% Principal Value at Period End as % of Total Mortgage- Backed Securities 62.55% 78.29% 73.90% 65.51% 68.60% 67.89% 73.28% 72.61% Principal Value as % of Total Mortgage-Backed Securities 37.45% 21.71% 26.10% 34.49% 31.40% 32.11% 26.72% 27.39% 16 Management’s Discussion and Analysis of Financial Condition and Results of Operations Annaly Mortgage Management, Inc. At December 31, 2002 we held mortgage-backed securities with coupons linked to the one-year, two-year, three-year, and five-year Treasury indices, one-month and one-year LIBOR, six-month Auction Average, twelve-month moving average and the six-month CD rate. At December 31, 2001 we held mortgage-backed securities with coupons linked to the one-year, three-year, and five-year Treasury indices, one-month and six-month LIBOR, six-month Auction Average, twelve-month moving average and the six-month CD rate. Adjustable-Rate Mortgage-Backed Securities by Index December 31, 2002 Weighted Average Adjustment Frequency Weighted Average Term to Next Adjustment Weighted Average Annual Period Cap Weighted Average Lifetime Cap at December 31, 2002 Mortgage Principal Value as Percentage of Mortgage-Backed Securities at December 31, 2002 One-Month LIBOR 1mo. 1mo. None 1-Year LIBOR 12 mo. 41 mo. 2.00% Six-Month Auction Average 6 mo. 2 mo. 2.00% 12-Month Moving Average 1 mo. 1 mo. None Six-Month CD Rate 6 mo. 2 mo. 1.00% 1-Year Treasury Index 2-Year Treasury Index 3-Year Treasury Index 5-Year Treasury Index 12 mo. 22 mo. 1.93% 24 mo. 10 mo. 2.00% 36 mo. 20 mo. 2.00% 60 mo. 31 mo. 2.00% 9.01% 11.31% 13.00% 10.37% 11.60% 11.83% 11.93% 12.83% 12.57% 32.43% 0.33% 0.03% 0.58% 0.14% 27.67% 0.03% 0.92% 0.42% Adjustable-Rate Mortgage-Backed Securities by Index December 31, 2001 Weighted Average Adjustment Frequency Weighted Average Term to Next Adjustment Weighted Average Annual Period Cap One-Month LIBOR Six-Month LIBOR 1mo. 1mo. None 6 mo. 55 mo. 2.00% Six-Month Auction Average 6 mo. 2 mo. 0.50% 12-Month Moving Average 12 mo. 11 mo. None Six-Month CD Rate 6 mo. 2 mo. 1.00% 1-Year Treasury Index 12 mo. 33 mo. 1.98% 3-Year Treasury Index 36 mo. 16 mo. 2.00% 5-Year Treasury Index 60 mo. 33 mo. 1.96% Weighted Average Lifetime Cap at December 31, 2001 9.09% 11.50% 12.53% 10.63% 11.40% 12.22% 13.08% 12.92% Mortgage Principal Value as Percentage of Mortgage-Backed Securities at December 31, 2001 18.32% 0.13% 0.12% 1.06% 0.22% 56.20% 1.35% 0.89% Adjustable-Rate Mortgage-Backed Securities by Index December 31, 2000 Weighted Average Adjustment Frequency Weighted Average Term to Next Adjustment Weighted Average Annual Period Cap Weighted Average Lifetime Cap at December 31, 2000 Mortgage Principal Value as Percentage of Mortgage-Backed Securities at December 31, 2000 One-Month LIBOR Six-Month CD Rate 1 mo. 1 mo. None 6 mo. 2 mo. 1.00% 1-Year Treasury Index 12 mo. 23 mo. 1.98% 3-Year Treasury Index 36 mo. 20 mo. 2.00% 5-Year Treasury Index 60 mo. 40 mo. 1.76% 9.11% 11.37% 12.61% 13.24% 12.42% 24.08% 1.21% 44.52% 2.97% 1.12% Borrowings To date, our debt has consisted entirely of borrowings collateralized by a pledge of our mortgage- backed securities. These borrowings appear on our balance sheet as repurchase agreements. At December 31, 2002, we had established uncommitted borrowing facilities in this market with 25 lenders in amounts, which we believe, are in excess of our needs. We believe that we have used approximately 57% of our uncommitted borrowing line. All of our mortgage-backed securities are currently accepted as collateral for these borrowings. However, we limit our borrowings, and thus our potential asset growth, in order to maintain unused borrowing capacity and thus increase the liquidity and strength of our balance sheet. At December 31, 2002, we had collateral in excess of the required haircut on our repurchase agreements in the amount of $677.7 million. For the year ended December 31, 2002, the term to maturity of our borrowings ranged from one day to three years, with a weighted average original term to maturity of 166 days at December 31, 2002. For the years ended December 31, 2001 and 2000, the term to maturity of our borrowings ranged from one day to three years, with a weighted average original term to maturity of 119 days at December 31, 2001, and 56 days at December 31, 2000. At December 31, 2002, the weighted average cost of funds for all of our borrowings was 1.72% and the weighted average term to next rate adjustment was 124 days. At December 31, 2001, the weighted average cost of funds for all of our borrowings was 2.18% and the weighted average term to next rate adjustment was 85 days. At December 31, 2000, the weighted average cost of funds for all of our borrowings was 6.55% and the weighted average term to next rate adjustment was 29 days. At December 31, 2001, the weighted average original term increased because of the use of three year repurchase agreements. Management’s Discussion and Analysis of Financial Condition and Results of Operations Annaly Mortgage Management, Inc. 17 Liquidity Liquidity, which is our ability to turn non-cash assets into cash, allows us to purchase additional mortgage-backed securities and to pledge additional assets to secure existing borrowings should the value of our pledged assets decline. Potential immediate sources of liquidity for us include cash balances and unused borrowing capacity. Unused borrowing capacity will vary over time as the market value of our mortgage-backed securities varies. Our balance sheet also generates liquidity on an on-going basis through mortgage principal repayments and net earnings held prior to payment as dividends. Should our needs ever exceed these on-going sources of liquidity plus the immediate sources of liquidity discussed above, we believe that our mortgage-backed securities could in most circumstances be sold to raise cash. The maintenance of liquidity is one of the goals of our capital investment policy. Under this policy, we limit asset growth in order to preserve unused borrowing capacity for liquidity management purposes. Stockholders’ Equity We use “available-for-sale” treatment for our mortgage-backed securities; we carry these assets on our balance sheet at estimated market value rather than historical amortized cost. Based upon this “available-for-sale” treatment, our equity base at December 31, 2002 was $1.1 billion, or $12.77 per share. If we had used historical amortized cost accounting, our equity base at December 31, 2002 would have been $1.0 billion, or $11.88 per share. Our equity base at December 31, 2001 was $667.4 million, or $11.15 per share. If we had used historical amortized cost accounting, our equity base at December 31, 2001 would have been $629.2 million, or $10.52 per share. Our equity base at December 31, 2000 was $135.6 million, or $9.34 per share. If we had used historical amortized cost accounting, our equity base at December 31, 2000 would have been $148.6 million, or $10.24 per share. Unrealized Gains and Losses Through the Equity Shelf Program, in which we sell shares from time-to-time at market prices, we raised approximately $28.1 million in net proceeds and issued 1,484,100 shares during 2002. Also in 2002, 165,480 shares were purchased through our dividend reinvestment and share purchase plan, totaling approximately $3.0 million. We also completed an offering of common stock in the first quarter issuing 23,000,000 shares, with aggregate net proceeds of approximately $347.4 million. We completed three public offerings during the year ended December 31, 2001 in which we issued a total of 45,060,100 shares of common stock, and received aggregate net proceeds of approximately $474.2 million. With our “available-for-sale” accounting treatment, unrealized fluctuations in market values of assets do not impact our GAAP or taxable income but rather are reflected on our balance sheet by changing the carrying value of the asset and stockholders’ equity under “Accumulated Other Comprehensive Income (Loss).” By accounting for our assets in this manner, we hope to provide useful information to stockholders and creditors and to preserve flexibility to sell assets in the future without having to change accounting methods. As a result of this mark-to-market accounting treatment, our book value and book value per share are likely to fluctuate far more than if we used historical amortized cost accounting. As a result, comparisons with companies that use historical cost accounting for some or all of their balance sheet may not be meaningful. The table below shows unrealized gains and losses on the mortgage-backed securities in our portfolio. (dollars in thousands) 2002 2001 Unrealized Gain Unrealized Loss Net Unrealized Gain (Loss) Net Unrealized Gain (Loss) as % of Mortgage- Backed Securities Principal Value Net Unrealized Gain (Loss) as % of Mortgage- Backed Securities Amortized Cost $ 90,507 (14,997) $ 75,510 $ 53,935 (15,766) $ 38,169 At December 31, 2000 $ 3,020 (16,064) ($13,044) 1999 1998 $ 1,531 (39,100) ($37,569) $ 3,302 (9,706) ($6,404) 0.67% 0.67% 0.52% 0.51% (0.66%) (2.59%) (0.43%) (0.66%) (2.54%) (0.42%) Unrealized changes in the estimated net market value of mortgage-backed securities have one direct effect on our potential earnings and dividends: positive marked-to-market changes increase our equity base and allow us to increase our borrowing capacity while negative changes tend to limit borrowing capacity under our capital investment policy. A very large negative change in the net market value of our mortgage-backed securities might impair our liquidity position, requiring us to sell assets with the likely result of realized losses upon sale. The net unrealized gains (loss) on available for sale securities was $75.5 million, or 0.67% or the amortized cost of our mortgage- backed securities as of December 31, 2002, $38.2 million, or 0.51% or the amortized cost of our mortgage-backed securities as of December 31, 2001, and $13.0 million, or 0.66% of the amortized cost of our mortgage-backed securities at December 31, 2000. The table on the following page shows our equity capital base as reported and on a historical amor- tized cost basis at December 31, 2002, 2001, 2000, 1999, and 1998, and September 30, 2002, June 30, 2002 and March 31,2002. Issuances of common stock, the level of earnings as compared to dividends declared, and other factors influence our historical cost equity capital base. The reported equity capital base is influenced by these factors plus changes in the “Net Unrealized Losses on Assets Available for Sale” account. 18 Management’s Discussion and Analysis of Financial Condition and Results of Operations Annaly Mortgage Management, Inc. Stockholders’ Equity (dollars in thousands, except per share data) At December 31, 2002 At December 31, 2001 At December 31, 2000 At December 31, 1999 At December 31, 1998 At September 30, 2002 At June 30, 2002 At March 31, 2002 Historical Amortized Cost Equity Base $1,004,555 $ 629,188 $ 148,686 $ 140,841 $ 132,275 $1,010,623 $ 982,348 $ 978,186 Net Unrealized Gains on Assets Available for Sale $ 75,511 $ 38,169 ($13,044) ($37,569) ($ 6,404) $ 74,382 $ 67,283 $ 30,502 Reported Equity Base (Book Value) Historical Amortized Cost Equity Per Share Reported Equity (Book Value) Per Share $1,080,066 $ 667,357 $ 135,642 $ 103,272 $ 125,871 $1,085,005 $1,049,631 $1,008,688 $11.88 $10.52 $10.24 $10.37 $10.46 $11.96 $11.84 $11.80 $12.77 $11.15 $ 9.34 $ 7.60 $ 9.95 $12.84 $12.65 $12.17 Leverage Our debt-to-equity ratio at December 31, 2002, 2001, and 2000 was 9.4:1, 9.5:1, and 12.0:1, respectively. We generally expect to maintain a ratio of debt-to-equity of between 8:1 and 12:1, although the ratio may vary from this range from time-to-time based upon various factors, including our management’s opinion of the level of risk of our assets and liabilities, our liquidity position, our level of unused borrowing capacity and over-collateralization levels required by lenders when we pledge assets to secure borrowings. Inflation Virtually all of our assets and liabilities are financial in nature. As a result, interest rates and other factors drive our performance far more than does inflation. Changes in interest rates do not neces- sarily correlate with inflation rates or changes in inflation rates. Our financial statements are pre- pared in accordance with GAAP and our dividends based upon our net income as calculated for tax purposes; in each case, our activities and balance sheet are measured with reference to historical cost or fair market value without considering inflation. Our target debt-to-equity ratio is determined under our capital investment policy. Should our actual debt-to-equity ratio increase above the target level due to asset acquisition or market value fluctu- ations in assets, we will cease to acquire new assets. Our management will, at that time, present a plan to our board of directors to bring us back to our target debt-to-equity ratio; in many circumstances, this would be accomplished over time by the monthly reduction of the balance of our mortgage-backed securities through principal repayments. Asset/Liability Management and Effect of Changes in Interest Rates We continually review our asset/liability management strategy with respect to interest rate risk, mortgage prepayment risk, credit risk and the related issues of capital adequacy and liquidity. Our goal is to provide attractive risk-adjusted stockholder returns while maintaining what we believe is a strong balance sheet. We seek to manage the extent to which our net income changes as a function of changes in interest rates by matching adjustable-rate assets with variable-rate borrowings. In addition, although we have not done so to date, we may seek to mitigate the potential impact on net income of periodic and lifetime coupon adjustment restrictions in our portfolio of mortgage-backed securities by entering into interest rate agreements such as interest rate caps and interest rate swaps. Changes in interest rates may also affect the rate of mortgage principal prepayments and, as a result, prepayments on mortgage-backed securities. We will seek to mitigate the effect of changes in the mortgage principal repayment rate by balancing assets we purchase at a premium with assets we purchase at a discount. To date, the aggregate premium exceeds the aggregate discount on our mort- gage-backed securities. As a result, prepayments, which result in the expensing of unamortized pre- mium, will reduce our net income compared to what net income would be absent such prepayments. Other Matters We calculate that our qualified Real Estate Investment Trust (“REIT”) assets, as defined in the Internal Revenue Code, are 100.0% of our total assets at December 31, 2002, 2001, and 2000 as compared to the Internal Revenue Code requirement that at least 75% of our total assets be qualified REIT assets. We also calculate that 100% of our revenue qualifies for the 75% source of income test, and 100% of its revenue qualifies for the 95% source of income test, under the REIT rules for the years ended December 31, 2002, 2001, and 2000. We also met all REIT requirements regarding the ownership of our common stock and the distribution of our net income. Therefore, as of December 31, 2002, 2001, and 2000 we believe that we qualified as a REIT under the Internal Revenue Code. We at all times intend to conduct our business so as not to become regulated as an investment company under the Investment Company Act of 1940, as amended (the “Investment Company Act”). If we were to become regulated as an investment company, then our use of leverage would be sub- stantially reduced. 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” (qualifying interests). Under current interpretation of the staff of the SEC, in order to qualify for this exemption, we must maintain at least 55% of our assets directly in qualifying interests. In addition, unless certain mortgage securitites represent all the certificates issued with respect to an underlying pool of mortgages, the mortgage-backed securities may be treated as securities separate from the underlying mortgage loans and, thus, may not be considered qualifying interests for purposes of the 55% requirement. We calculate that as of December 31, 2002, 2001, and 2000 we were in compliance with this requirement. Independent Auditors’ Report Annaly Mortgage Management, Inc. 19 19 To the Board of Directors and Stockholders of Annaly Mortgage Management, Inc. We have audited the accompanying statements of financial condition of Annaly Mortgage Management, Inc. (the “Company”) as of December 31, 2002 and 2001, and the related statements of operations, changes in stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2002. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the finan- cial statements. An audit also includes assessing the accounting principles used and significant esti- mates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such financial statements present fairly, in all material respects, the financial posi- tion of the Company at December 31, 2002 and 2001, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States of America. New York, New York February 26, 2003 20 Statements of Financial Condition (dollars in thousands) Annaly Mortgage Management, Inc. December 31, Assets Cash and Cash Equivalents Mortgage-Backed Securities — At fair value Receivable for Mortgage-Backed Securities Sold Accrued Interest Receivable Other Assets Total Assets Liabilities and Stockholders’ Equity Liabilities: Repurchase agreements Payable for Mortgage-Backed Securities purchased Accrued interest payable Dividends payable Other liabilities Accounts payable Total liabilities Stockholders’ Equity: Common stock: par value $.01 per share; 500,000,000 authorized, 84,569,206 and 59,826,975 shares issued and outstanding, respectively Additional paid-in capital Accumulated other comprehensive income Retained earnings Total stockholders’ equity Total Liabilities and Stockholders’ Equity See notes to financial statements. 2002 2001 $ 726 11,551,857 55,954 49,707 840 $11,659,084 $10,163,174 338,691 14,935 57,499 2,812 1,907 10,579,018 846 1,003,200 75,511 509 1,080,066 $ 429 7,575,379 94,503 46,804 199 $7,717,314 $6,367,710 627,064 16,043 35,896 2,010 1,234 7,049,957 598 623,986 38,169 4,604 667,357 $11,659,084 $ 7,717,314 Statements of Operations (dollars in thousands, except for per share data) Years Ended December 31, Interest Income: Annaly Mortgage Management, Inc. 21 2002 2001 2000 Mortgage-Backed Securities and cash equivalents $ 404,165 $ 263,058 $ 109,751 Interest Expense: Repurchase agreements Net Interest Income Gain on Sale of Mortgage-Backed Securities General and Administrative Expenses Net Income Other Comprehensive Gain: Unrealized gain on available-for-sale securities Less reclassification adjustment for gains included in net income Other comprehensive gain Total Comprehensive Income Net Income Per Share: Basic Diluted Average Number of Shares Outstanding: Basic Diluted See notes to financial statements. 191,758 212,407 21,063 13,963 219,507 58,405 (21,063) 37,342 168,055 95,003 4,586 7,311 92,278 55,800 (4,586) 51,214 92,902 16,849 2,025 2,287 16,587 26,549 (2,025) 24,524 $ 256,849 $ 143,492 $ 41,111 $ $ 2.68 2.67 $ $ 2.23 2.21 $ $ 1.18 1.15 82,044,141 82,282,883 41,439,631 41,857,498 14,089,436 14,377,459 22 Statements of Stockholders’ Equity (dollars in thousands) Annaly Mortgage Management, Inc. Balance, December 31, 1999 Net income Other comprehensive income: Unrealized net gains on securities, net of reclassification adjustment Comprehensive income Exercise of stock options Proceeds from direct purchase Dividends declared for the year ended December 31, 2000, $1.15 per share Balance, December 31, 2000 Net income Other comprehensive income: Unrealized net gains on securities, net of reclassification adjustment Comprehensive income Exercise of stock options Shares exchanged upon exercise of stock options Proceeds from direct purchase Proceeds from secondary offerings Dividends declared for the year ended December 31, 2001, $1.75 per share Balance, December 31, 2001 Net income Other comprehensive income: Unrealized net gains on securities, net of reclassification adjustment Comprehensive income Exercise of stock options Shares exchanged upon exercise of stock options Proceeds from direct purchase Proceeds from secondary offerings Proceeds from equity shelf program Dividends declared for the year ended December 31, 2002, $2.67 per share Balance, December 31, 2002 See notes to financial statements Comprehensive Income $ 16,587 24,524 $ 41,111 $ 92,278 51,214 $143,492 $219,507 37,342 $256,849 Common Stock Par Value 135 — — — — 9 — 144 — — — 3 — Additional Paid-in Capital 140,263 — — — 198 7,384 — 147,845 — — — 2,972 (587) 142 451 473,614 — $598 — — — 1 2 230 15 — — $623,986 — — — 1,089 (76) 3,007 347,106 28,088 — Retained Earnings 443 16,587 — — — — (16,333) 697 92,278 — — — — — (88,371) 4,604 219,507 — — — — — — (223,602) Accumulated Other Comprehensive Income (Loss) Total (37,569) 103,272 — — 24,524 — — — — 41,111 198 7,393 (16,333) (13,045) 135,641 — — 51,214 — — — — — — 38,169 — 37,342 — — — — — — 143,492 2,975 (587) 142 474,065 (88,371) 667,357 256,849 1,090 (76) 3,009 347,336 28,103 (223,602) $846 $1,003,200 $509 $75,511 $1,080,066 Statement of Cash Flows (dollars in thousands) Annaly Mortgage Management, Inc. 23 Years Ended December 31, 2002 2001 2000 $ 219,507 $ 92,278 $ 16,587 Cash Flows From Operating Activities: Net income Adjustments to reconcile net income to net cash provided by operating activities: Amortization of mortgage premiums and discounts, net Market value adjustment on long term repurchase agreement Gain on sale of Mortgage-Backed Securities Stock option expense Increase in accrued interest receivable (Increase) decrease in other assets (Decrease) increase in accrued interest payable Increase in other liabilities and accounts payable Net cash provided by operating activities Cash Flows From Investing Activities: Purchase of Mortgage-Backed Securities Proceeds from sale of Mortgage-Backed Securities Principal payments on Mortgage-Backed Securities Net cash used in investing activities Cash Flows From Financing Activities: Proceeds from repurchase agreements Principal payments on repurchase agreements Proceeds from exercise of stock options Proceeds from direct equity offering Proceeds from secondary offerings Dividends paid Net cash provided by financing activities Net Increase in Cash and Cash Equivalents Cash and Cash Equivalents, Beginning of Year 106,198 1,204 (21,063) 240 (2,903) (641) (1,109) 673 302,106 (11,079,561) 2,076,800 4,728,666 (4,274,095) 87,463,924 (83,668,862) 774 3,010 375,439 (201,999) 3,972,286 297 429 726 36,865 986 (4,587) 790 (35,301) 61 7,729 950 99,771 (8,194,215) 1,248,812 1,685,874 (5,259,529) 49,773,650 (45,033,275) 1,597 142 474,065 (56,105) 5,160,074 316 113 429 $ 2,647 — (2,025) — (4,645) (62) 1,631 120 14,253 (952,738) 489,810 168,517 (294,411) 14,196,953 (13,906,890) 199 7,393 - (17,456) 280,199 41 72 113 91,270 (24,524) 3,631 $ $ $ $ Cash and Cash Equivalents, End of Year $ Supplemental Disclosure of Cash Flow Information: Interest paid Noncash Financing Activities: Net change in unrealized loss on available-for-sale securities Dividends declared, not yet paid See notes to financial statements. $ 190,650 $ 160,327 $ $ 37,342 57,499 $ $ 51,214 35,896 24 24 Notes to Financial Statements Notes to Financial Statements Notes to Financial Statements Annaly Mortgage Management, Inc. Annaly Mortgage Management, Inc. 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES Annaly Mortgage Management, Inc. (the “Company”) was incorporated in Maryland on November 25, 1996. The Company commenced its operations of purchasing and managing an investment portfo- lio of Mortgage-Backed Securities on February 18, 1997, upon receipt of the net proceeds from the private placement of equity capital. An initial public offering was completed on October 14, 1997. A summary of the Company’s significant accounting policies follows: Cash and Cash Equivalents– Cash and cash equivalents includes cash on hand and money market funds. The carrying amount of cash equivalents approximates their value. Mortgage-Backed Securities– The Company invests primarily in mortgage pass-through certificates, collateralized mortgage obligations and other mortgage-backed securities representing interests in or obligations backed by pools of mortgage loans (collectively, “Mortgage-Backed Securities”). Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities, requires the Company to classify its investments as either trading investments, available-for-sale investments or held-to-maturity investments. Although the Company generally intends to hold most of its Mortgage-Backed Securities until maturity, it may, from time to time, sell any of its Mortgage-Backed Securities as part of its overall management of its balance sheet. Accordingly, this flexibility requires the Company to classify all of its Mortgage-Backed Securities as available-for-sale. All assets classified as available-for-sale are reported at fair value, based on mar- ket prices provided by certain dealers who make markets in these financial instruments, with unre- alized gains and losses excluded from earnings and reported as a separate component of stock- holders’ equity. Unrealized losses on Mortgage-Backed Securities that are considered other than temporary, as measured by the amount of decline in fair value attributable to factors other than temporary, are recognized in income and the cost basis of the Mortgage-Backed Securities is adjusted. There were no such adjustments for the years ended December 31, 2002, 2001, and 2000. Interest income is accrued based on the outstanding principal amount of the Mortgage-Backed Securities and their contractual terms. Premiums and discounts associated with the purchase of the Mortgage-Backed Securities are amortized into interest income over the lives of the securities using the interest method. Mortgage-Backed Securities transactions are recorded on the trade date. Purchases of newly issued securities are recorded when all significant uncertainties regarding the characteristics of the secu- rities are removed, generally shortly before settlement date. Realized gains and losses on Mortgage- Backed Securities transactions are determined on the specific identification basis. Credit Risk– At December 31, 2002 and 2001, the Company has limited its exposure to credit loss- es on its portfolio of Mortgage-Backed Securities by only purchasing securities issued by Federal Home Loan Mortgage Corporation (“FHLMC”), Federal National Mortgage Association (“FNMA”), or Government National Mortgage Association (“GNMA”). The payment of principal and interest on the FHLMC and FNMA Mortgage-Backed Securities are guaranteed by those respective agencies and the payment of principal and interest on the GNMA Mortgage-Backed Securities are backed by the full-faith-and-credit of the U.S. government. At December 31, 2002 and 2001, all of the Company’s Mortgage-Backed Securities have an implied “AAA” rating. Repurchase Agreements– The Company finances the acquisition of its Mortgage-Backed Securities through the use of repurchase agreements. Repurchase Agreements are treated as collateralized financing transactions and are carried at their contractual amounts, including accrued interest, as specified in the repurchase agreements. Accrued interest is recorded as a seperate line item. Income Taxes– The Company has elected to be taxed as a Real Estate Investment Trust (“REIT”) and intends to comply with the provisions of the Internal Revenue Code of 1986, as amended (the “Code”) with respect thereto. Accordingly, the Company will not be subjected to federal income tax to the extent of its distributions to shareholders and as long as certain asset, income and stock own- ership tests are met. Use of Estimates– The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. New Accounting Pronouncement– In December 2002, the FASB issued Statement of Financial Accounting Standard (SFAS) No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosures, an Amendment of FASB Statement No. 123.” This Statement provides alternative meth- ods of transition for companies who voluntarily change to the fair value-based method of accounting for stock-based employee compensation in accordance with SFAS No. 123, “Accounting for Stock- Based Compensation.” (SFAS 123). SFAS No. 148 does not permit the use of the original SFAS No. 123 prospective method of transition for changes to the fair value based method made in fiscal years beginning after December 15, 2003. The Statement also requires prominent disclosures in both annu- al and interim financial statements about the method of accounting for stock-based compensation and the effect of the method used on reported results. This Statement is effective upon issuance 2. MORTGAGE-BACKED SECURITIES The following table pertains to the Company’s Mortgage-Backed Securities classified as available- for-sale as of December 31, 2002, which are carried at their fair value: (dollars in thousands) Mortgage-Backed Securities, gross Unamortized discount Unamortized premium Amortized cost Gross unrealized gains Gross unrealized losses Estimated fair value Adjustable Rate Fixed Rate Total Federal Home Loan Mortgage Corporation $ 5,120,929 (544) 105,872 5,226,257 31,731 (9,554) $ 5,248,434 Amortized Cost $ 7,144,741 4,331,606 $11,476,347 Federal National Mortgage Association $5,860,987 (120) 164,071 6,024,938 58,239 (5,318) $ 6,077,859 Gross Unrealized Gain $ 35,349 55,158 $ 90,507 Government National Mortgage Association $220,468 — 4,684 225,152 537 (125) Total Mortgage- Backed Securities $11,202,384 (664) 274,627 11,476,347 90,507 (14,997) $225,564 $11,551,857 Gross Unrealized Loss $(12,424) (2,573) $(14,997) Estimated Fair Value $ 7,167,666 4,384,191 $11,551,857 Notes to Financial Statements Annaly Mortgage Management, Inc. 25 The following table pertains to the Company’s Mortgage-Backed Securities classified as available- for-sale as of December 31, 2001, which are carried at their fair value: (dollars in thousands) Federal Home Loan Mortgage Corporation Federal National Mortgage Association Government National Mortgage Association Total Mortgage- Backed Securities Mortgage-Backed Securities, gross $ 4,426,195 $2,894,026 $ 79,720 $ 7,399,941 Unamortized discount Unamortized premium Amortized cost Gross unrealized gains Gross unrealized losses Estimated fair value Adjustable Rate Fixed Rate Total (1,346) 83,775 4,508,624 32,636 (7,986) (755) 54,118 2,947,389 21,224 (7,314) — 1,477 81,197 75 (466) (2,101) 139,370 7,537,210 53,935 (15,766) $ 4,533,274 $2,961,299 $ 80,806 $ 7,575,379 Amortized Cost $5,908,236 1,628,974 $ 7,537,210 Gross Unrealized Gain $ 44,469 9,466 $ 53,935 Gross Unrealized Loss $(10,049) (5,717) $ (15,766) Estimated Fair Value $5,942,656 1,632,723 $ 7,575,379 The adjustable rate Mortgage-Backed Securities are limited by periodic caps (generally interest rate adjustments are limited to no more than 1% every six months) and lifetime caps. The weighted average lifetime cap was 8.8% and 11.5% at December 31, 2002 and 2001, respectively. During the year ended December 31, 2002, the Company realized $21.1 million in gains from sales of Mortgage-Backed Securities. During the year ended December 31, 2001, the Company realized $6.8 million in gains from sales of Mortgage-Backed Securities. Losses totaled $2.2 million for the year ended December 31, 2001. During the year ended December 31, 2000, the Company realized $2.0 million in gains from sales of Mortgage-Backed Securities. 3. REPURCHASE AGREEMENTS The Company had outstanding $10,163,174,000 and $6,367,710,000 of repurchase agreements with a weighted average borrowing rate of 1.72% and 2.18% and a weighted average remaining matu- rity of 124 days and 85 days as of December 31, 2002 and 2001, respectively. At December 31, 2002 and 2001, Mortgage-Backed Securities pledged had an estimated fair value of $10,517,558,000 and $6,564,250,000, respectively. At December 31, 2002 and 2001 the repurchase agreements had the following remaining maturities: (dollars in thousands) Within 30 days 30 to 59 days 60 to 89 days 90 to 119 days Over 120 days 2002 $ 7,778,003 816,906 104,500 — 1,463,765 $10,163,174 2001 $5,380,006 206,947 66,202 65,037 649,518 $ 6,367,710 4. OTHER LIABILITIES In 2001, the Company entered into a repurchase agreement maturing in July 2004, at which time, the repurchase agreement gives the buyer the right to extend, in whole or in part, in three-month increments up to July 2006. The repurchase agreement has a principal value of $100,000,000. The Company accounts for the extension option as a separate interest rate floor liability carried at fair value. The initial fair value of $1,200,000 allocated to the extension option resulted in a similar dis- count on the repurchase agreement borrowings that is being amortized over the initial term of 3 years using the effective yield method. At December 31, 2002, the fair value of this interest rate floor was a $2,812,000 and was classified as other liabilities. The aggregate charge of $1,204,000 and $986,000 is included in interest expense for 2002 and 2001, respectively. 5. COMMON STOCK During the Company’s year ending December 31, 2002, the Company declared dividends to share- holders totaling $223,602,000, or $2.67 per share, of which $166,102,000 was paid during the year and $57,499,000 was paid on January 29, 2003. During the year ended December 31, 2002, 97,095 options were exercised at $1,090,000. Total shares exchanged upon exercise of the stock options were 4,444 at a value of $76,000. Through the Equity Shelf Program, the Company raised $28,103,000 in net proceeds and issued 1,481,000 shares. Also, 165,480 shares were purchased in dividend reinvestment and share purchase plan, totaling $3,009,000. The Company completed an offering of common stock in the first quarter issuing 23,000,000 shares, with aggregate net pro- ceeds of $347.3 million. During the Company’s year ending December 31, 2001, the Company declared dividends to share- holders totaling $88,370,451, or $1.75 per share, of which $52,474,266 was paid during the year and $35,896,185 was paid on January 30, 2002. During the year ended December 31, 2001, 274,231 options were exercised at $2,974,666. Total shares exchanged upon exercise of the stock options were 41,620 at a value of $588,068. Also, 10,856 shares were purchased in dividend reinvestment and share purchase plan, totaling $142,456. The Company completed an offering of 26 Notes to Financial Statements Annaly Mortgage Management, Inc. 26 common stock in the third quarter issuing 14,991,600 shares, with aggregate net proceeds of $179.6 million. An offering of common stock during the second quarter of 2001 was completed issuing 18,918,500 shares, with aggregate net proceeds of $195.3 million. Additional offerings for 11,150,000 shares were completed during the first quarter for aggregate net proceeds of $99.3 million. During the Company’s year ending December 31, 2000, the Company declared dividends to share- holders totaling $16,333,252, or $1.15 per share, of which $12,702,507 was paid during the year and $3,630,745 was paid on January 30, 2001. During the year ended December 31, 2000, 47,499 options were exercised at $198,762. Also, 894,163 shares were purchased in direct offerings, total- ing $7,392,859. 6. EARNINGS PER SHARE (EPS) For the year ended December 31, 2002, the reconciliation is as follows: For the Year Ended December 31, 2002 (dollars in thousands, except for per share data) Income (Numerator) Shares (Denominator) Per Share Amount Net income Basic EPS Effect of dilutive securities: Dilutive stock options Diluted EPS $219,507 219,507 — $219,507 82,044,141 $2.68 238,742 82,282,883 $2.67 Options to purchase 6,250 shares of stock were outstanding and considered anti-dillutive as their exercise price exceeded the average stock price for the year. For the year ended December 31, 2001, the reconciliation is as follows: For the Year Ended December 31, 2001 (dollars in thousands, except for per share data) Income (Numerator) Shares (Denominator) Per Share Amount Net income Basic EPS Effect of dilutive securities: Dilutive stock options Diluted EPS $92,278 92,278 — $92,278 41,439,631 $2.23 417,867 41,857,498 $2.21 Options to purchase 6,250 shares of stock were outstanding and considered anti-dilutive as their exercise price exceeded the average stock price for the year. For the year ended December 31, 2000, the reconciliation is as follows: For the Year Ended December 31, 2000 (dollars in thousands, except for per share data) Income (Numerator) Shares (Denominator) Per Share Amount Net income Basic EPS Effect of dilutive securities: Dilutive stock options Diluted EPS $16,587 16,587 — $16,587 14,089,436 $1.18 288,023 14,377,459 $1.15 Options to purchase 568,926 shares of stock were outstanding and considered anti-dilutive. The exercise price exceeded the average stock price for the year. Notes to Financial Statements Annaly Mortgage Management, Inc. 27 7. LONG-TERM STOCK INCENTIVE PLAN The Company has adopted a long term stock incentive plan for executive officers, key employ- ees and nonemployee directors (the “Incentive Plan”). The Incentive Plan authorizes the Compensation Committee of the board of directors to grant awards, including incentive stock options as defined under Section 422 of the Code (“ISOs”) and options not so qualified (“NQSOs”). The Incentive Plan authorizes the granting of options or other awards for an aggre- gate of the greater of 500,000 shares or 9.5% of the fully diluted outstanding shares of the Company’s common stock. The following table sets forth activity relating to the Company’s stock options awards 2002 2001 2000 Options outstanding at the beginning of period Granted Exercised Expired Options outstanding at the end of period Options exercisable at end of period Number of Shares 635,826 6,250 (97,095) (32,275) 512,706 393,076 Weighted Average Exercise Price $ 8.48 20.35 8.75 8.28 $ 8.59 $ 8.67 The following table summarizes information about stock options outstanding at December 31, 2002: Range of Exercise Price $7.94-$19.99 $20.00-$29.99 Number of Shares 903,807 6,250 (274,231) 635,826 335,328 Options Outstanding 506,456 6,250 512,706 Weighted Average Exercise Price $ 8.28 13.69 7.95 $ 8.48 $ 8.63 Number of Shares 844,056 122,500 (47,499) (15,250) 903,807 341,226 Weighted Average Exercise Price 8.44 20.35 8.59 Weighted Average Exercise Price $ 8.03 8.00 4.18 9.17 $ 8.28 $ 8.72 Weighted Average Remaining Contractual Life (Yrs.) 6.5 4.5 6.5 The Company accounts for the incentive plan under the intrinsic value method in accordance with APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. No stock- based employee compensation cost is reflected in net income, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share if the com- pany had applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation. For the Year Ended December 31, (dollars in thousands, except per share data) 2002 2001 2000 Net income, as reported Deduct: Total stock-based employee compensation expense determined under fair value based method Pro-forma net income Net income per share, as reported Basic Diluted Pro-forma net income per share Basic Diluted $219,507 (33) $219,474 $ $ $ $ 2.68 2.67 2.68 2.67 $92,278 (266) $92,012 $ 2.23 $ 2.21 $ 2.22 $ 2.20 $16,587 (118) $16,469 $ 1.18 $ 1.17 $ 1.17 $ 1.15 28 Notes to Financial Statements Annaly Mortgage Management, Inc. 28 The weighted average fair value at date of grant for stock options granted during the year ended December 31, 2002, 2001 and 2000 was $0.83, $0.89 and $0.43 per option, respectively. The fair value of stock options at date of grant was estimated using the Black-Scholes option pricing model utilizing the following weighted average assumptions: For the Year Ended December 31, 2002 2001 2000 Risk-free interest rate Expected option life in years Expected stock price volatility Expected dividend yield 4.02% 5 26% 13.57% 4.21% 5 28% 15.32% 5.16% 5 28% 12.69% 8. COMPREHENSIVE INCOME The Company adopted Statement of Financial Accounting Standards No. 130, Reporting Comprehensive Income. Statement No. 130 requires the reporting of comprehensive income in addi- tion to net income from operations. Comprehensive income is a more inclusive financial reporting methodology that includes disclosure of certain financial information that historically has not been recognized in the calculation of net income. The Company at December 31, 2002 and 2001 held securities classified as available-for-sale. At December 31, 2002, the net unrealized gains totaled $75,511,000 and at December 31, 2001, the net unrealized losses totaled $38,169,000. 9. LEASE COMMITMENTS The Corporation has a noncancelable lease for office space, which commenced in May 2002 and expires in December 2009. The Corporation’s aggregate future minimum lease payments are as follows: (dollars in thousands) 10. RELATED PARTY TRANSACTION Included in “Other Assets” on the Balance sheet as of December 31, 2001 is an investment in Annaly International Money Management, Inc. On June 24, 1998, the Company acquired 99,960 nonvoting shares, at a cost of $49,980. Annaly International Money Management, Inc. was liquidated during the year, resulting in a $44,000 loss, which is reflected in “Gain on Sale of Securities,” in the Statement of Operations. The officers and directors of Annaly International Money Management Inc. are also officers and directors of the Company. Officers and employees of the Company are active- ly involved in managing Mortgage-Backed Securities and other fixed income assets for institutional clients through Fixed Income Discount Advisory Company (“FIDAC”). FIDAC is a registered invest- ment adviser, which is owned 100% by the Chief Executive Officer of Annaly Mortgage Management, Inc. Our management currently allocates rent and other general and administrative expenses 90% to Annaly and 10% to FIDAC. 11. INTEREST RATE RISK The primary market risk to the Company is interest rate risk. Interest rates are highly sensitive to many factors, including governmental monetary and tax policies, domestic and international eco- nomic and political considerations and other factors beyond the Company’s control. Changes in the general level of interest rates can affect net interest income, which is the difference between the interest income earned on interest-earning assets and the interest expense incurred in connection with the interest-bearing liabilities, by affecting the spread between the interest-earning assets and interest-bearing liabilities. Changes in the level of interest rates also can affect the value of the mort- gage-backed securities and the Company’s ability to realize gains from the sale of these assets. The Company seeks to manage the extent to which net income changes as a function of changes in interest rates by matching adjustable-rate assets with variable-rate borrowings. In addition, although the Company has not done so to date, the Company may seek to mitigate the potential impact on net income of periodic and lifetime coupon adjustment restrictions in the portfolio of mort- gage-backed securities by entering into interest rate agreements such as interest rate caps and inter- est rate swaps. Total per Year 2003 2004 2005 2006 2007 thereafter Total remaining lease payments 500 500 500 530 532 1,064 $3,626 Changes in interest rates may also have an effect on the rate of mortgage principal prepayments and, as a result, prepayments on mortgage-backed securities. The Company will seek to mitigate the effect of changes in the mortgage principal repayment rate by balancing assets purchased at a premium with assets purchased at a discount. To date, the aggregate premium exceeds the aggre- gate discount on the mortgage-backed securities. As a result, prepayments, which result in the expensing of unamortized premium, will reduce net income compared to what net income would be absent such prepayments. Notes to Financial Statements Annaly Mortgage Management, Inc. 29 12. SUMMARIZED QUARTERLY RESULTS (UNAUDITED) The following is a presentation of the quarterly results of operations for the year ended December 31, 2002. Quarters Ending (dollars in thousands) Interest income from Mortgage-Backed Securities and cash $ Interest expense on repurchase agreements Net interest income Gain on sale of Mortgage-Backed Securities General and administrative expenses Net income Net income per share: Basic Diluted Average number of shares outstanding: Basic Diluted $ $ $ March 31, 2002 92,900 40,012 52,888 3,410 3,255 53,043 0.69 0.69 June 30, 2002 September 30, 2002 $ 109,423 $ 109,201 47,860 61,563 1,343 3,536 59,370 0.72 0.71 $ $ $ 54,012 55,189 4,747 3,268 56,668 0.68 0.68 $ $ $ December 31, 2002 92,641 49,874 42,767 11,563 3,904 50,426 0.60 0.60 $ $ $ $ 76,709,836 77,017,431 82,910,206 83,186,865 83,668,422 83,939,870 84,525,171 84,766,747 Quarters Ending (dollars in thousands) Interest income from Mortgage-Backed Securities and cash $ Interest expense on repurchase agreements Net interest income Gain on sale of Mortgage-Backed Securities General and administrative expenses Net income Net income per share: Basic Diluted Average number of shares outstanding: Basic Diluted Interest expense on repurchase agreements Net interest income Gain on sale of Mortgage-Backed-Securities General and administrative expenses Net income Net income per share: Basic Diluted Average number of shares outstanding: Basic Diluted Quarters Ending (dollars in thousands) Interest income from Mortgage-Backed Securities and cash $ $ $ $ $ $ $ March 31, 2000 24,617 19,293 5,324 107 582 4,849 0.35 0.35 13,660,539 13,971,112 March 31, 2001 42,434 33,453 8,981 269 921 8,329 0.38 0.37 June 30, 2001 September 30, 2001 $ 64,790 45,284 19,506 482 1,393 18,595 0.48 0.48 $ $ $ $ $ $ $ 75,775 48,620 27,155 1,184 1,993 26,346 0.58 0.57 December 31, 2001 $ 80,059 40,698 39,361 2,651 3,004 39,008 0.65 0.65 $ $ $ 21,851,481 22,535,210 38,473,928 39,054,488 45,503,179 45,959,693 59,776,777 60,155,994 $ June 30, 2000 25,735 21,453 4,282 65 507 $ 3,840 $ $ 0.27 0.26 14,039,741 14,631,940 September 30, 2000 December 31, 2000 $ 28,239 $ 31,160 24,779 3,460 873 527 3,806 0.27 0.26 $ $ $ 27,377 3,783 981 670 4,094 0.28 0.28 $ $ $ 14,238,680 14,529,142 14,413,578 14,702,189 30 Common Stock and Market Information Annaly Mortgage Management, Inc. The following table sets forth, for the periods indicated, the high, low, and closing sales prices per share of common stock as reported on the New York Stock Exchange composite tape and the cash dividends declared per share of our common stock. Stock Prices First Quarter ended March 31, 2002 Second Quarter ended June 30, 2002 Third Quarter ended September 30, 2002 Fourth Quarter ended December 31, 2002 First Quarter ended March 31, 2001 Second Quarter ended June 30, 2001 Third Quarter ended September 30, 2001 Fourth Quarter ended December 31, 2001 We intend to pay quarterly dividends and to distribute to our stockholders all or substantially all of our taxable income in each year (subject to certain adjustments). This will enable us to qualify for the tax benefits accorded to a REIT under the Code. We have not established a minimum dividend payment level and our ability to pay dividends may be adversely affected for the reasons described under the caption “Risk Factors” in the 2002 Form 10-k. All distributions will be made at the dis- cretion of our Board of Directors and will depend on our earnings, our financial condition, mainte- nance of our REIT status and such other factors as our Board of Directors may deem relevant from time to time. High Low Close Cash Dividends Declared Per Share $17.62 $21.50 $20.40 $19.55 $11.50 $13.76 $14.93 $17.01 $15.30 $16.20 $14.00 $15.25 $ 8.75 $10.50 $12.70 $13.20 $16.98 $19.40 $18.45 $18.80 $11.26 $13.71 $14.45 $16.00 $0.63 $0.68 $0.68 $0.68 $0.30 $0.40 $0.45 $0.60 Corporate Information Annaly Mortgage Management, Inc. 31 Corporate Officers Board of Directors Corporate Headquarters Michael A. J. Farrell Chairman of the Board, President & Chief Executive Officer Michael A. J. Farrell Chairman of the Board, President & Chief Executive Officer Wellington J. Denahan Vice Chairman & Chief Investment Officer Wellington J. Denahan Vice Chairman & Chief Investment Officer Kathryn F. Fagan Chief Financial Officer & Treasurer Kevin P. Brady Founder & Principal KPB Associates Jennifer A. Stephens Executive Vice President & Corporate Secretary Spencer I. Browne Former President & Chief Executive Officer Asset Investors Corporation James P. Fortescue Senior Vice President Kristopher R. Konrad Senior Vice President Rose-Marie Lyght Vice President Jeremy Diamond Executive Vice President Jonathan D. Green President & Chief Financial Officer Rockefeller Group International, Inc. John A. Lambiase Former Managing Director Salomon Brothers, Inc. Ronald D. Kazel Senior Vice President Donnell A. Segalas Phoenix Investment Partners, Ltd. Annaly Mortgage Management, Inc. 1211 Avenue of the Americas, Suite 2902 New York, New York 10036 Legal Counsel McKee Nelson LLP 1919 M. Street, NW Suite 800 Washington, D.C. 20036 Auditors Deloitte & Touche L.L.P. Two World Financial Center New York, New York 10281-1434 Stock Transfer Agent Shareholder inquiries concerning dividend payments, lost certificates, change of address: Mellon Investors Services, L.L.C PO Box 3315 South Hackensack, New Jersey 07606-1163 www.mellon-investor.com Stock Exchange Listing The common stock is listed on the New York Stock Exchange (symbol: NLY). Annual Meeting The Annual Meeting of Stockholders will be held Thursday, May 15, 2003 at 10:30 am at: The Union League Club 38 East 37th Street New York, New York 10178 Shareholder Communications Copies of the Company’s Annual Report and Financials may be obtained by writing the Corporate Secretary, by calling the investor relations hot line at 888-8ANNALY, or by visiting our website www.annaly.com. Cover: Workers on Wall Street © Bettman / CORBIS Page 5: War Effort Garden Contest Poster © Minnesota Historical Society / CORBIS Page 7: Rosie the Riveter © 1943 SEPS: Licensed by Curtis Publishing, Indianapolis, IN. All rights reserved. www.curtispublishing.com Design: Langton Cherubino Group / NYC © 2003 Annaly Mortgage Management, Inc. Annaly Mortgage Management, Inc. 1211Avenue of theAmericas Suite 2902 New York, New York 10036 1.888.8ANNALY www.annaly.com 

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