Anworth Mortgage Asset Corporation Annual Report 2004

FY2004 Annual Report · Anworth Mortgage Asset Corporation

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Anworth Mortgage Asset Corporation

Annual Report

2004

SELECTED FINANCIAL DATA

The selected financial data as of December 31, 2004 and 2003 and for the years ended December 31, 2004,

2003 and 2002 are derived from our audited financial statements included in this Form 10-K. The selected
financial data as of December 31, 2002, 2001 and 2000 and for the years ended December 31, 2001 and 2000 are
derived from audited financial statements not included in this Form 10-K. You should read these selected
financial data together with “Management’s Discussion and Analysis of Financial Condition and Results of
Operations” and our audited and unaudited financial statements and notes thereto that are included in this
Form 10-K beginning on page F-1.

Consolidated Statements of Income Data
Days in period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interest income net of amortization of premium

Year Ended December 31,

2000

2001

2002

2003

2004

(amounts in thousands, except per share data)

366

365

366

and discount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 10,314 $ 10,768 $

(6,363)
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
4,405
Net interest income . . . . . . . . . . . . . . . . . . . . . . . . . .
430
Gain on sales of securities . . . . . . . . . . . . . . . . . . . . .
—
Net gain on derivative instruments . . . . . . . . . . . . . .
(1,129)
Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3,706
Income from operations before minority interest . . .
—
Minority interest in net income of a subsidiary . . . .
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $
3,706 $
Dividend on preferred stock . . . . . . . . . . . . . . . . . . . $ — $ — $
3,706 $
Net income available to common stockholders . . . . $

(8,674)
1,640
—
—
(379)
1,261
—
1,261 $

1,261 $

66,855 $ 100,077 $ 163,023
(97,949)
(45,661)
(29,576)
65,074
54,416
37,279
259
3,497
4,709
340
—
—
(9,575)
(7,718)
(10,318)
56,098
50,195
31,670
(293)
—
—
55,805
50,195 $
31,670 $
(369)
— $
— $
55,436
50,195 $
31,670 $

Basic earnings per share available to common

stockholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $

0.54 $

1.52 $

1.81 $

1.52 $

1.23

Average number of shares outstanding . . . . . . . . . . .

2,331

2,442

17,461

32,927

45,244

Diluted earnings per share available to common

stockholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $

0.54 $

1.50 $

1.80 $

1.52 $

1.22

Average number of diluted shares outstanding . . . . .

2,331

2,467

17,591

33,112

45,329

Preferred Stock dividends declared per share . . . . . . $ — $ — $

Common Stock dividends declared per share(1)

. . . $

0.40 $

1.64 $

— $

2.00 $

— $ 0.335417

1.56 $

1.25

At December 31,

2000

2001

2002

2003

2004

(amounts in thousands, except per share data)

Consolidated Balance Sheets Data
Agency mortgage-backed securities, net . . . . . . . . . . $134,889 $420,214 $2,430,103 $4,245,853 $4,588,541
— $2,628,334
Residential real estate loans . . . . . . . . . . . . . . . . . . . $ — $ — $
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $141,834 $424,610 $2,443,884 $4,263,274 $7,319,070
Repurchase agreements . . . . . . . . . . . . . . . . . . . . . . . $121,891 $325,307 $2,153,870 $3,775,691 $4,717,436
— $ 556,233
Whole loan financing facilities . . . . . . . . . . . . . . . . . $ — $ — $
— $1,494,851
Mortgage-backed securities issued . . . . . . . . . . . . . . $ — $ — $
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $123,633 $369,613 $2,178,362 $3,805,877 $6,811,803
Stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . $ 18,201 $ 54,997 $ 265,522 $ 457,397 $ 507,036
46,497
Number of common shares outstanding . . . . . . . . . .
10.31
Book value per share . . . . . . . . . . . . . . . . . . . . . . . . . $

42,707
10.71 $

25,346
10.48 $

6,951
7.91 $

2,350
7.75 $

— $
— $

— $

(1) On September 26, 2000, our board of directors announced that, beginning with the third quarter of 2000,

dividends would generally be declared after each quarter-end rather than during the applicable quarter.

Anworth Mortgage Asset Corporation

2004 Annual Report

Dear fellow shareholders,

I am writing to update you on the condition of our company.

During 2004, our Net Income was $55,436,000, or $1.22 per common share, compared to $50,195,000, or
$1.52 per common share, earned during 2003. Dividends declared during 2004 were $1.25 per share. Based on
our stock price of $10.71 as of December 31, 2004, these dividends represented an 11% dividend yield to our
shareholders.

The year 2004 contained several important milestones for our company:

•

Our subsidiary, Belvedere Trust Mortgage Corporation, whose business strategy is to acquire and
securitize high quality jumbo residential mortgage loans had, as of December 31 2004, acquired and
owned $2.6 billion of these mortgage assets.

In November, we issued $26 million of a new Series A Preferred Stock which provided investors an
8.625% yield and is listed on the New York Stock Exchange.

Including our Series A Preferred Stock issuance, our paid-in equity capital increased from $489 million
to $561 million.

We believe that the business of Belvedere Trust will benefit Anworth shareholders by providing both an
additional method of acquiring mortgage-related assets and additional diversification and stability in the income
from which we pay dividends.

This increase in the amount of shareholders’ capital is an important benefit for our company because the

costs of running our business usually do not increase proportionately with the increase in capital. When this
happens, there is usually more Net Income per share from which we pay dividends to you, our shareholders.

After this increase in paid-in capital at year end, we had 46,497,000 common shares outstanding for which
we had received $535 million in capital, which is $11.51 per common share. It is one of our long-term goals to
increase the paid-in capital per common share so that there is more capital per share on which we can earn
income to pay dividends.

Our Business Strategy

When you review our financial statements, you will notice that our business profitability has six basic
components which, when combined, result in our Net Income for the year. A simplified formula that can be used
to calculate our Net Income is:

Interest Income minus Interest Expense minus Amortization of Premium minus Credit Loss minus Operating
Costs plus Capital Gains equals our Net Income.

While many of these terms are familiar to most of our shareholders, I believe that presenting a description of

each is periodically a good idea.

Interest Income—The interest we receive from our investment in residential mortgage loans and residential

mortgage-backed securities. With 45,329,000 being the average number of diluted shares outstanding during
2004, this amount was $214,426,000 or $4.73 per share.

Interest Expense—The interest we pay on the short-term and long-term collateralized borrowings that we
use to acquire most of our residential mortgages and residential mortgage-backed securities. In 2004, this amount
was $97,949,000 or $2.16 per share.

Amortization of Premium—The residential mortgage loans and residential mortgage-backed securities
which we purchase usually have interest rates that are higher than comparable quality bonds selling at par.
Offsetting this higher interest rate, we usually are required to pay a premium above the par value of our
residential mortgage loans and residential mortgage-backed securities. When the homeowners repay a mortgage
loan which we own, we expense the premium which we paid to purchase that mortgage asset. In 2004, this
amount was $51,403,000 or $1.13 per share.

Capital Gains—Whenever we sell an asset, we will recognize either a gain or loss. Since tax regulations
discourage us from making large volumes of sales, these transactions are not frequent. In 2004, gains from the
sales of mortgage assets and derivative hedging instruments amounted to $599,000 or $0.01 per share.

Credit Losses—While our Agency mortgage-backed securities are issued primarily by Fannie Mae or
Freddie Mac, who guarantee against loss, our residential mortgage loan portfolio is usually not guaranteed
against loss by anyone other than the homeowner. Each year, we set aside an actuarially calculated percentage of
these loans as a reserve against future losses. If the losses do not occur, we will eventually return the excess
reserves to the shareholders. In 2004, the amount of this reserve was $591,000. In 2004, no actual losses were
realized and charged against the reserve.

Operating Costs—These costs include the expenses normally associated with running a business. Like most

businesses, we pay our employees a salary and benefits and we pay rent on our offices. Due to the complex
nature of mortgage analytics, we utilize expensive computer software and hardware. We also retain lawyers,
accountants and other advisers to assist us in the management of our business. In 2004, this amount was
$8,984,000 or $0.20 per share, and represented an expense of about 0.12% of the company’s $7 billion of
mortgage assets.

Net Income—After we have used part of our Interest Income to pay all of these expenses, what is left is our

Net Income, which is what we use to pay dividends to you, our shareholders. As noted above, our Net Income
available to common shareholders in 2004 was $55,436,000 or $1.22 per share.

Form 10-K

As you read the attached Annual Report on Form 10-K, which is on file with the United States Securities

and Exchange Commission, you will observe that our book value per share, which includes unrealized gains and
losses as of December 31, 2004, declined to $10.31 per share from $10.71 per share on December 31, 2003.

You will also note that our portfolio is now divided into two components. One is our traditional portfolio of

mortgage-backed securities issued by Fannie Mae, Freddie Mac or Ginnie Mae which we call our Agency
portfolio. The other is our portfolio of high quality jumbo mortgage loans which we call our Whole Loan
portfolio.

Our Agency portfolio consists of 31% in adjustable-rate mortgage-backed securities with interest rate resets

within one year, 64% in adjustable-rate mortgage-backed securities resetting between one and five years, 4% in
fixed-rate mortgage-backed securities and 1% agency floating-rate CMOs. At year end, all of these securities
were issued by Fannie Mae, Freddie Mac or Ginnie Mae.

In our Form 10-K, you will also note the results of our securitization activities which provided the long-term
financing of our portfolio of mortgage loans acquired through Belvedere Trust. We have created these mortgage-
backed securities through our subsidiary, BellaVista Mortgage Trust, which issues these non-recourse debt

securities. These securities, of which about 95% are rated AAA, have been acquired primarily by institutional
investors worldwide. The BellaVista Mortgage Trust registration documents filed with the Securities and
Exchange Commission can be retrieved from the SEC’s website, www.sec.gov, by entering “BellaVista” as the
issuer’s name.

Interest Rate Outlook

We presently envision that the short-term rate increases of 2004 will likely continue in 2005. We also
believe that, unless there is a sudden increase in global instability from terrorist or other geopolitical activities
resulting in a material weakness in the U.S. dollar, the United States economy should, as a whole, continue to
improve moderately, resulting in interest rate increases that would also be moderate. For Anworth, such
moderation should result in an environment that produces lower mortgage loan refinancing and, consequently,
lower amortization expense to counter the probably narrowing spread between the yield on our assets and our
cost of financing.

During 2004, the Federal Reserve changed its monetary policy from accommodative to restrictive as the
U.S. economy began to slowly pick up some steam. The Federal Reserve signaled its concern about the prospects
of rising speculation and inflation when it increased its target Fed Funds rate six times from 1.00% in June 2004
to the current level of 2.50%.

The result of this increase in short–term interest rates was a significant increase in our cost of borrowing to

finance our Agency portfolio, which increased from 1.51% at year-end 2003 to 2.34% at year-end 2004. The
coupon rate on our Agency portfolio declined from 4.31% at year-end 2003 to 4.28% at year-end 2004.

Our Stock’s Return

Anworth’s year-end closing price on the New York Stock Exchange was $10.71. This decline in our stock’s

price, along with the dividends received, resulted in a return to investors of approximately minus 14%, which is
the first negative total return in several years. Even with this recent negative return and since our initial public
offering in March 1998 at $9.00 per share, and with dividends reinvested at market prices, our stock has provided
investors with a compounded positive annual return of 17% per year through December 31, 2004.

This compounded return was achieved during a period when stocks in general failed to produce the types of

returns which many investors had come to expect to fund their retirements and lifestyle choices. During this
period, the S&P 500 stock index with dividends provided a compounded return of about 2% per year.

Our Series A Preferred Stock

As mentioned above, we issued in November a Series A Preferred Stock which trades on the New York

Stock Exchange. The issue price was $25.00 per share and the annual dividend rate is 8.625%. The dividend is
scheduled to be paid on the 15th of the first month in each calendar quarter. If you are interested in more details
about the Preferred Stock, a copy of its prospectus is available on the www.sec.gov website.

If the profitability level of the company continues to exceed the cost of paying the dividend to our preferred
shareholders, it will result in more earnings and dividends for our common shareholders. We also understand that
many investors seek a more predictable quarterly income from their investment portfolio and will find our
preferred stock more suitable than our common stock, whose dividends have fluctuated significantly.

Dividend Reinvestment and Stock Purchase Plan

We believe that our Dividend Reinvestment and Stock Purchase Plan continues to be an attractive benefit of

common stock ownership. Common stockholders can, without brokerage commissions, reinvest their dividends
in additional shares of Anworth common stock at a discount of 5% of the average market price. In addition,

shareholders and investors can, each month, purchase up to an additional $10,000 in Anworth shares at the
market price less the current discount rate of 1%. Please call or e-mail us to receive a prospectus that describes
the particulars of the Plan before you join or invest.

Anworth.com

The size of our investor e-mail list continues to grow and we are always pleased to add interested investors

to the list for news releases and the like. You can register yourself for e-mail alerts at our website,
www.anworth.com, where you can also get information about our corporate governance procedures, presentations
to investor groups and other statistical information.

Our Philosophy

We continue to believe that our company is well suited to participate in the mortgage finance industry and
provide a valuable service to residential homeowners. Many financial institutions that originate mortgage loans
no longer believe that keeping these loans in their portfolios is the most efficient use of their capital. Therefore,
these originators often promptly sell their residential mortgage loans to more permanent mortgage investors like
Anworth.

Anworth is now a significant financial intermediary mortgage organization with its being a long-term

beneficial owner of more than $7 billion of residential mortgage assets.

Many large institutional investors tend to speculate in mortgage rates and add to mortgage rate volatility.
We believe that we can improve mortgage rate stability by permanently owning residential mortgage securities
and loans in a very capital-efficient and tax-efficient manner. We believe that, over the long-term, Anworth and
the home-owning public can benefit significantly from this trend.

Annual Stockholders’ Meeting

As always, we invite you to attend our annual stockholders’ meeting in Santa Monica with the Pacific
Ocean and the famous Will Rogers state beach right outside our windows. And if that and our doughnuts aren’t
enough, we also give interesting demonstrations of the technology used to evaluate our residential mortgage-
backed securities and their convexity! I am confident that those who have come in the past will agree that we
provide good weather and an interesting and informative experience. If you need information regarding
directions, hotels, restaurants, etc, please give us a call.

As always, I thank you for your continued support.

Lloyd McAdams, CFA
Chairman and Chief Executive

SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-K
È ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 OF THE SECURITIES

EXCHANGE ACT OF 1934

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2004

‘ TRANSACTION REPORT PURSUANT TO SECTION 13 OR 15 OF THE

SECURITIES EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM

COMMISSION FILE NUMBER 001-13709

ANWORTH MORTGAGE ASSET
CORPORATION

(Exact Name of Registrant as Specified in Its Charter)

MARYLAND
(State or Other Jurisdiction of
Incorporation Organization)

1299 OCEAN AVENUE, #250, SANTA MONICA,
CALIFORNIA
(Address of Principal Executive Offices)

52-2059785
(I.R.S. Employer
Identification No.)

90401
(Zip Code)

Registrant’s telephone number, including area code: (310) 255-4493
Securities registered pursuant to Section 12(b) of the Act: NONE
Securities registered pursuant to Section 12(g) of the Act:

PREFERRED STOCK, $0.01 PAR VALUE
COMMON STOCK, $0.01 PAR VALUE

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or

15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to filing requirements for the past 90 days.
Yes È No ‘

Indicate by check mark that disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not

contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. ‘

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).

Yes È No ‘

The aggregate market value of the voting stock held by non-affiliates of the registrant, computed by
reference to the average closing bid and asked prices of such stock, as of June 30, 2004, was approximately
$526,764,665 (All officers and directors of the registrant are considered affiliates).

At March 14, 2005 the registrant had 1,610,500 shares of Series A Cumulative Preferred Stock issued and

outstanding and 47,160,111 shares of Common Stock issued and outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Part III of the Form 10-K incorporates by reference certain portions of the Registrant’s proxy statement for
its 2005 annual meeting of stockholders to be filed with the Commission not later than 120 days after the end of
the fiscal year covered by this report.

ANWORTH MORTGAGE ASSET CORPORATION

FORM 10-K ANNUAL REPORT

FISCAL YEAR ENDED DECEMBER 31, 2004

TABLE OF CONTENTS

Item

1. Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2. Property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3. Legal Proceedings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
4. Submission of Matters to a Vote of Security Holders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

PART I

PART II

5. Market for Registrant’s Common Equity and Related Stockholder Matters . . . . . . . . . . . . . . . . . . . . .
6. Selected Financial Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
7. Management’s Discussion and Analysis of Financial Condition and Results of Operations . . . . . . . .
7A. Qualitative and Quantitative Disclosures About Market Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
8. Financial Statements and Supplementary Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure . . . . . . . .
9A. Controls and Procedures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
9B. Other Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

PART III

10. Directors and Executive Officers of the Registrant . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
11. Executive Compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
12. Security Ownership of Certain Beneficial Owners and Management . . . . . . . . . . . . . . . . . . . . . . . . . .
13. Certain Relationships and Related Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
14. Principal Accountant Fees and Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Page

1
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29
29

30
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33
61
64
64
65
67

68
68
68
68
68

15. Exhibits, Financial Statement Schedules and Reports on Form 8-K . . . . . . . . . . . . . . . . . . . . . . . . . . .

PART IV

[THIS PAGE INTENTIONALLY LEFT BLANK]

CAUTIONARY STATEMENT

This Report contains or incorporates by reference certain forward-looking statements. Forward-looking
statements are those that predict or describe future events or trends and that do not relate solely to historical
matters. You can generally identify forward-looking statements as statements containing the words “will,”
“believe,” “expect,” “anticipate,” “intend,” “estimate,” “assume” or other similar expressions. You should not
rely on our forward-looking statements because the matters they describe are subject to known and unknown
risks, uncertainties and other unpredictable factors, many of which are beyond our control. These forward-
looking statements are subject to assumptions that are difficult to predict and to various risks and uncertainties.
Therefore, our actual results could differ materially and adversely from those expressed in any forward-looking
statements as a result of various factors, some of which are listed under the section “Risk Factors” at the end of
Item 7 of this Report. We undertake no obligation to revise or update publicly any forward-looking statements
for any reason.

As used in this Form 10-K, “company,” “we,” “us,” “our,” “Anworth” and “Anworth Mortgage” refer to

Anworth Mortgage Asset Corporation.

Item 1. BUSINESS

Overview

PART I

We are in the business of investing primarily in United States agency and other highly rated single-family
adjustable-rate and fixed-rate mortgage-backed securities and residential mortgage loans that we acquire in the
secondary market. United States agency securities are securities that are obligations guaranteed by the United
States government or its sponsored enterprises or agencies such as Fannie Mae (FNM), Freddie Mac (FHLMC)
or Ginnie Mae (GNMA). We seek attractive long-term investment returns by investing our equity capital and
borrowed funds in such securities. Our returns are principally earned on the spread between the yield on our
interest-earning assets and the interest cost of the funds we borrow.

We were incorporated in Maryland on October 20, 1997 and commenced our operations on March 17, 1998.

From the time of our inception through June 13, 2002, we were externally managed pursuant to a management
agreement with Anworth Mortgage Advisory Corporation, or the manager. As an externally managed company,
we had no employees of our own and relied on the manager to conduct our business and operations. On June 13,
2002, the manager merged with and into our company. As a result of the merger, we are an internally managed
company.

On November 3, 2003, we formed our wholly-owned subsidiary, Belvedere Trust Mortgage Corporation, or

Belvedere Trust. Belvedere Trust was formed to acquire, own and securitize mortgage loans, with a focus on
high credit-quality jumbo adjustable-rate, hybrid and second-lien mortgages. Belvedere Trust acquires mortgage
loans, securitizes a substantial amount of those mortgage loans and then retains a portion of the mortgage-backed
securities, while selling the balance to third parties in the secondary market. The mortgage-backed securities it
retains are purchased by one of our qualified REIT subsidiaries to maximize tax efficiency on the interest income
on those securities. Since its formation, Belvedere Trust has become an increasingly important part of our overall
operations. As of December 31, 2004, we had made an investment of approximately $96 million in Belvedere
Trust to capitalize its mortgage operations.

Belvedere Trust is externally managed by BT Management Company, L.L.C., or BT Management, a
Delaware limited liability company that is owned 50% by Anworth and 50% by the executive officers of
Belvedere Trust. BT Management manages Belvedere Trust through a management agreement with Belvedere
Trust pursuant to which BT Management manages the day-to-day operations of Belvedere Trust in exchange for
an annual base management fee and a quarterly incentive fee.

At December 31, 2004, we had total assets of $7.3 billion. Our portfolio consisted of $4.6 billion of agency

mortgage-backed securities allocated as follows: 31% agency adjustable-rate mortgage-backed securities, 64%
agency hybrid adjustable-rate mortgage-backed securities, 4% agency fixed-rate mortgage-backed securities and
1% agency floating-rate CMOs. Our non-agency mortgage-backed securities held at December 31, 2004 were
approximately $63 million, mostly retained from our first whole loan securitization. Mortgage loans held for
securitization at December 31, 2004 were $578 million and securitized mortgage loans were $2.05 billion. As of
December 31, 2004, Belvedere Trust’s assets comprised 37% of our overall assets, or approximately $2.7 billion
in mortgage-related assets. Our total equity at December 31, 2004 was $507 million. Common stockholders’
equity was approximately $480 million, or $10.31 per share. For the year ended December 31, 2004, we reported
net income of $55.8 million, or $1.22 per diluted share available to common stockholders.

We have elected to be taxed as a real estate investment trust, or REIT, under the United States Internal
Revenue Code (“the tax code”). As a REIT, we routinely distribute substantially all of the income generated from
our operations to our stockholders. As long as we retain our REIT status, we generally will not be subject to
federal or state taxes on our income to the extent that we distribute our net income to our stockholders. Certain
direct and indirect subsidiaries of Belvedere Trust are taxable REIT subsidiaries and, as such, are liable for
corporate income tax expenses.

Our Strategy

Investment Strategy

Our strategy is to invest primarily in United States agency and other highly rated single-family

adjustable-rate and fixed-rate mortgage-backed securities that we acquire in the secondary market and, through
our investment in our subsidiary, Belvedere Trust, we invest in primarily high quality jumbo residential real
estate mortgage loans. We seek to acquire assets that will produce competitive returns after considering the
amount and nature of the anticipated returns from the investment, our ability to pledge the investment to secure
collateralized borrowings and the costs associated with financing, managing, securitizing and reserving for these
investments. We do not currently originate mortgage loans or provide other types of financing to the owners of
real estate. Through Belvedere Trust, we also acquire mortgage loans with a focus on high credit-quality jumbo
adjustable-rate, hybrid and second-lien mortgages. Mortgage loans may be purchased from various suppliers of
mortgage-related assets throughout the United States, including savings and loans associations, banks, mortgage
bankers and other mortgage lenders. We may acquire mortgage loans directly from originators and from entities
which hold mortgage loans originated by others.

Financing Strategy

We finance the acquisition of mortgage-related assets with short-term borrowings and, to a lesser extent,
equity capital. The amount of short-term borrowings we employ depends on, among other factors, the amount of
our equity capital. We use leverage to attempt to increase potential returns to our stockholders. Pursuant to our
capital and leverage policy, we seek to strike a balance between the under-utilization of leverage, which reduces
potential returns to stockholders, and the over-utilization of leverage, which could reduce our ability to meet our
obligations during adverse market conditions.

We usually borrow at short-term rates using repurchase agreements. Repurchase agreements are generally
short-term in nature. We actively manage the adjustment periods and the selection of the interest rate indices of
our borrowings against the adjustment periods and the selection of indices on our mortgage-related assets in
order to limit our liquidity and interest rate-related risks. We generally seek to diversify our exposure by entering
into repurchase agreements with multiple lenders. In addition, we enter into repurchase agreements with major
lending institutions we believe are financially sound and are approved by our board of directors.

We finance our acquisition of residential real estate mortgage loans using long-term debt (obligations due

on pass-through certificates or bonds) through securitizations. The interest rates on the long-term debt are
variable and are based either upon the interest rates on the underlying loan collateral or upon LIBOR (London

Interbank Offered Rate). The maturities on the long-term debt are also based upon the maturities of the
underlying mortgages. In addition, we enter into whole loan warehouse financing facilities to finance our
residential loan acquisitions prior to securitization. The whole loan warehouse financing facilities are short-term
borrowings that are secured by the loans.

Growth Strategy

In addition to the strategies described above, we intend to pursue other strategies to further grow our

earnings and our dividends per share which may include the following:

•

increasing the size of our consolidated balance sheets at a rate faster than the rate of increase in our
operating expenses;

issuing new preferred stock and common stock when market opportunities exist to profitably increase
the size of our consolidated balance sheets through the use of leverage; and

lowering our effective borrowing costs over time by seeking direct funding with collateralized lenders
rather than using financial intermediaries, and possibly using commercial paper, medium-term note
programs, preferred stock and other forms of capital.

Our Operating Policies and Programs

We have established the following four primary operating policies to implement our business strategies:

•

our Asset Acquisition Policy;

our Capital and Leverage Policy;

our Credit Risk Management Policy; and

our Asset/Liability Management Policy.

Asset Acquisition Policy

Our Asset Acquisition Policy provides guidelines for acquiring investments and contemplates that we will
acquire a portfolio of investments that can be grouped into specific categories. Each category and our respective
investment guidelines are as follows:

•

Category I—At least 60% of our total assets will generally be adjustable- or fixed-rate mortgage
securities and short-term investments. Assets in this category will be rated within one of the two
highest rating categories by at least one nationally recognized statistical rating organization, or if not
rated, will be obligations guaranteed by the United States government or its agencies, Fannie Mae or
Freddie Mac. Also included in Category I are the portion of real estate mortgage loans that have been
deposited into a trust and have received a rating within one of the two highest rating categories by at
least one nationally recognized statistical rating organization.

Category II—At least 90% of our total assets will generally consist of Category I investments plus
unsecuritized mortgage loans, mortgage securities rated at least investment grade by at least one
nationally recognized statistical rating organization, or shares of other REITs or mortgage-related
companies and the portion of real estate mortgage loans that have been deposited into a trust and have
received an investment grade rating by at least one nationally recognized statistical rating organization.

Category III—No more than 10% of our total assets may be of a type not meeting any of the above
criteria. Among the types of assets generally assigned to this category are mortgage securities rated
below investment grade and leveraged mortgage derivative securities.

Under our Category III investment criteria, we may acquire other types of mortgage derivative securities

including, but not limited to, interest-only, principal-only or other mortgage-backed securities that receive a
disproportionate share of interest income or principal.

Capital and Leverage Policy

We employ a leverage strategy to increase our investment assets by borrowing against existing mortgage-

related assets and using the proceeds to acquire additional mortgage-related assets. Relative to our investment in
investment grade agency mortgage-backed securities, we generally borrow between eight to twelve times the
amount of our equity allocated to these investments. Our borrowings may vary from time to time depending on
market conditions and other factors deemed relevant by our management and our board of directors. We believe
that this will leave an adequate capital base to protect against interest rate environments in which our borrowing
costs might exceed our interest income from mortgage-related assets. We enter into collateralized borrowings
with major lending institutions which we believe are financially sound and are approved by our board of
directors.

Depending on the different cost of borrowing funds at different maturities, we may vary the maturities of

our borrowed funds in an attempt to produce lower borrowing costs. Our borrowings are short-term and we
manage actively, on an aggregate basis, both the interest rate indices and interest rate adjustment periods of our
borrowings against the interest rate indices and interest rate adjustment periods on our mortgage-related assets.

Our mortgage-related assets are financed primarily at short-term borrowing rates through repurchase
agreements and dollar-roll agreements. In the future, we may also employ borrowings under lines of credit and
other collateralized financings that we may establish with approved institutional lenders.

Belvedere Trust principally employs securitization to finance its ownership of real estate mortgage loans.

Credit Risk Management Policy

We review credit risk and other risks of loss associated with each of our potential investments. In addition,

we may diversify our portfolio of mortgage-related assets to avoid undue geographic, insurer, industry and
certain other types of concentrations. We may reduce certain risks from sellers and servicers through
representations and warranties. Our board of directors monitors the overall portfolio risk and determines
appropriate levels of provision for losses.

Compliance with our Credit Risk Management Policy guidelines is determined at the time of purchase of
mortgage assets based upon the most recent valuation utilized by us. Such compliance is not affected by events
subsequent to such purchase including, without limitation, changes in characterization, value or rating of any
specific mortgage assets or economic conditions or events generally affecting any mortgage-related assets of the
type held by us.

Asset/Liability Management Policy

Interest Rate Risk Management. To the extent consistent with our election to qualify as a REIT, we follow
an interest rate risk management program intended to protect our portfolio of mortgage-related assets and related
debt against the effects of major interest rate changes. Specifically, our interest rate management program is
formulated with the intent to offset, to some extent, the potential adverse effects resulting from rate adjustment
limitations on our mortgage-related assets and the differences between interest rate adjustment indices and
interest rate adjustment periods of our adjustable-rate mortgage-related assets and related borrowings.

Our interest rate risk management program encompasses a number of procedures, including the following:

•

monitoring and adjusting, if necessary, the interest rate sensitivity of our mortgage-related assets
compared with the interest rate sensitivities of our borrowings;

attempting to structure our borrowing agreements relating to adjustable-rate mortgage-related assets to
have a range of different maturities and interest rate adjustment periods (although substantially all will
be less than a year); and

actively managing, on an aggregate basis, the interest rate indices and interest rate adjustment periods
of our mortgage-related assets compared to the interest rate indices and adjustment periods of our
borrowings.

We expect to be able to adjust the average maturity/adjustment period of our borrowings on an ongoing

basis by changing the mix of maturities and interest rate adjustment periods as borrowings come due or are
renewed. Through the use of these procedures, we attempt to reduce the risk of differences between interest rate
adjustment periods of our adjustable-rate mortgage-related assets and our related borrowings.

Depending on market conditions and the cost of the transactions, we may conduct certain hedging activities

in connection with the management of our portfolio. To the extent consistent with our election to qualify as a
REIT, we may adopt a hedging strategy intended to lessen the effects of interest rate changes and to enable us to
earn net interest income in periods of generally rising, as well as declining or static, interest rates. Specifically,
hedging programs are formulated with the intent to offset some of the potential adverse effects of changes in
interest rate levels relative to the interest rates on the mortgage-related assets held in our investment portfolio and
differences between the interest rate adjustment indices and periods of our mortgage-related assets and our
borrowings. We monitor carefully, and may have to limit, our asset/liability management program to assure that
we do not realize excessive hedging income, or hold hedges having excess value in relation to mortgage-related
assets, which could result in our disqualification as a REIT or, in the case of excess hedging income, if the excess
is due to reasonable cause and not willful neglect, the payment of a penalty tax for failure to satisfy certain REIT
income tests under the tax code. In addition, asset/liability management involves transaction costs that increase
dramatically as the period covered by hedging protection increases and that may increase during periods of
fluctuating interest rates.

Prepayment Risk Management. We also seek to lessen the effects of prepayment of mortgage loans

underlying our securities at a faster or slower rate than anticipated. We accomplish this by structuring a
diversified portfolio with a variety of prepayment characteristics, investing in mortgage-related assets with
prepayment prohibitions and penalties, investing in certain mortgage security structures that have prepayment
protections and purchasing mortgage-related assets at a premium and at a discount. We invest in mortgage-
related assets that, on a portfolio basis, do not have significant purchase price premiums. Under normal market
conditions, we seek to maintain the aggregate capitalized purchase premium of the portfolio at 3% or less. In
addition, we can purchase principal-only derivatives to a limited extent as a hedge against prepayment risks. We
monitor prepayment risk through periodic review of the impact of a variety of prepayment scenarios on our
revenues, net earnings, dividends, cash flow and net consolidated balance sheets market value.

We believe that we have developed cost-effective asset/liability management policies to mitigate
prepayment risks. However, no strategy can completely insulate us from prepayment risks. Further, as noted
above, certain of the federal income tax requirements that we must satisfy to qualify as a REIT limit our ability to
fully hedge our prepayment risks. Therefore, we could be prevented from effectively hedging our interest rate
and prepayment risks.

Our Investments

Mortgage-Backed Securities

Pass-Through Certificates. We principally invest in pass-through certificates, which are securities
representing interests in pools of mortgage loans secured by residential real property in which payments of both
interest and principal on the securities are generally made monthly, in effect, “passing through” monthly
payments made by the individual borrowers on the mortgage loans which underlie the securities, net of fees paid
to the issuer or guarantor of the securities. Early repayment of principal on some mortgage-backed securities,
arising from prepayments of principal due to sale of the underlying property, refinancing or foreclosure, net of
fees and costs which may be incurred, may expose us to a lower rate of return upon reinvestment of principal.
This is generally referred to as “prepayment risk”. Additionally, if a security subject to prepayment has been
purchased at a premium, the unamortized value of the premium would be lost in the event of prepayment.

Like other fixed-income securities, when interest rates rise, the value of a mortgage-backed security
generally will decline. When interest rates are declining, however, the value of mortgage-backed securities with
prepayment features may not increase as much as other fixed-income securities. The rate of prepayments on

underlying mortgages will affect the price and volatility of mortgage-backed securities and may have the effect
of shortening or extending the effective maturity of the security beyond what was anticipated at the time of
purchase. When interest rates rise, our holdings of mortgage-backed securities may experience reduced returns if
the owners of the underlying mortgages pay off their mortgages later than anticipated. This is generally referred
to as “extension risk”.

Payment of principal and interest on some mortgage pass-through securities, though not the market value of

the securities themselves, may be guaranteed by the full faith and credit of the federal government, including
securities backed by Ginnie Mae, or by agencies or instrumentalities of the federal government, including Fannie
Mae and Freddie Mac. Mortgage-backed securities created by non-governmental issuers, including commercial
banks, savings and loan institutions, private mortgage insurance companies, mortgage bankers and other
secondary market issuers, may be supported by various forms of insurance or guarantees including individual
loan, title, pool and hazard insurance and letters of credit which may be issued by governmental entities, private
insurers or the mortgage poolers.

Collateralized Mortgage Obligations. Collateralized mortgage obligations, or CMOs, are mortgage-
backed securities. Interest and principal on a CMO are paid, in most cases, on a monthly basis. CMOs may be
collateralized by whole mortgage loans, but are more typically collateralized by portfolios of mortgage pass-
through securities. CMOs are structured into multiple classes, with each class bearing a different stated maturity.
Monthly payments of principal, including prepayments, are first returned to investors holding the shortest
maturity class; investors holding the longer maturity classes receive principal only after the first class has been
retired. We will typically consider CMOs that are issued or guaranteed by the federal government, or by any of
its agencies or instrumentalities, to be United States government securities.

Other Mortgage-Backed Securities

Mortgage Derivative Securities. We may acquire mortgage derivative securities in an amount not to

exceed 10% of our total assets. Mortgage derivative securities provide for the holder to receive interest-only,
principal-only or interest and principal in amounts that are disproportionate to those payable on the underlying
mortgage loans. Payments on mortgage derivative securities are highly sensitive to the rate of prepayments on
the underlying mortgage loans. In the event of faster or slower than anticipated prepayments on these mortgage
loans, the rates of return on interests in mortgage derivative securities, representing the right to receive interest-
only or a disproportionately large amount of interest or interest-only derivatives, would be likely to decline or
increase, respectively. Conversely, the rates of return on mortgage derivative securities, representing the right to
receive principal-only or a disproportionate amount of principal or principal-only derivatives, would be likely to
increase or decrease in the event of faster or slower prepayments, respectively.

We may invest in inverse floaters, a class of CMOs with a coupon rate that resets in the opposite direction

from the market rate of interest to which it is indexed, including LIBOR or the 11th District Cost of Funds Index,
or COFI. Any rise in the index rate, which can be caused by an increase in interest rates, causes a drop in the
coupon rate of an inverse floater, while any drop in the index rate causes an increase in the coupon of an inverse
floater. An inverse floater may behave like a leveraged security since its interest rate usually varies by a
magnitude much greater than the magnitude of the index rate of interest. The leverage-like characteristics
inherent in inverse floaters result in a greater volatility of their market prices.

We may invest in other mortgage derivative securities that may be developed in the future.

Subordinated Interests. We may acquire subordinated interests, which are classes of mortgage-backed

securities that are junior to other classes of the same series of mortgage-backed securities in the right to receive
payments from the underlying mortgage loans. The subordination may be for all payment failures on the
mortgage loans securing or underlying such series of mortgage securities. The subordination will not be limited
to those resulting from particular types of risks, including those resulting from war, earthquake or flood, or the
bankruptcy of a borrower. The subordination may be for the entire amount of the series of mortgage-related
securities or may be limited in amount.

Mortgage Warehouse Participations. We may occasionally acquire mortgage warehouse participations as

an additional means of diversifying our sources of income. We anticipate that these investments, together with
our investments in other Category III assets, will not in the aggregate exceed 10% of our total mortgage-related
assets. These investments are participations in lines of credit to mortgage loan originators secured by recently
originated mortgage loans that are in the process of being sold to investors. Our investments in mortgage
warehouse participations are limited because they are not qualified REIT assets under the tax code.

Other Mortgage-Related Assets

Mortgage Loans. We also acquire and accumulate mortgage loans through Belvedere Trust as part of our

investment strategy until a sufficient quantity has been accumulated for securitization into high-quality
mortgage-backed securities in order to enhance their value and liquidity. We anticipate that any mortgage loans
that we acquire and do not immediately securitize, together with our investments in other mortgage-related assets
that are not Category I assets, will not constitute more than 40% of our total mortgage-related assets at any time.
Mortgage loans are acquired with the intention of securitizing them into high-credit quality mortgage securities.
Despite our intentions, however, we may not be successful in securitizing these mortgage loans. To meet our
investment criteria, mortgage loans acquired by us will generally conform to the underwriting guidelines
established by Fannie Mae, Freddie Mac or to secondary market standards for “A” quality mortgage loans.
Applicable banking laws generally require that an appraisal be obtained in connection with the original issuance
of mortgage loans by the lending institution and we do not intend to obtain additional appraisals at the time of
acquiring mortgage loans.

Mortgage loans are purchased from various suppliers of mortgage-related assets throughout the United
States including savings and loans associations, banks, mortgage bankers and other mortgage lenders. We acquire
mortgage loans directly from originators and from entities holding mortgage loans originated by others. Our
board of directors has not established any limits upon the geographic concentration or the credit quality of
suppliers of the mortgage-related assets that we acquire.

Other Investments. We may acquire other investments that include equity and debt securities issued by

other primarily mortgage-related finance companies, interests in mortgage-related collateralized bond
obligations, other subordinated interests in pools of mortgage-related assets, commercial mortgage loans and
securities, and residential mortgage loans other than high-credit quality mortgage loans. Although we expect that
our other investments will be limited to less than 10% of total assets, we have no limit on how much of our
stockholders’ equity will be allocated to other investments. There may be periods in which other investments
represent a large portion of our stockholders’ equity.

Belvedere Trust Mortgage Corporation

Belvedere Trust’s Business. Belvedere Trust is in the business of acquiring, owning and securitizing

residential real estate loans, with a focus on high credit-quality jumbo adjustable-rate, hybrid and second-lien
mortgages. Belvedere Trust, through taxable REIT subsidiaries, acquires mortgage loans from various originators
and suppliers of mortgage-related assets throughout the United States, including savings and loan associations,
banks, and mortgage bankers. Belvedere Trust has built relationships with and continues to expand upon a
diversified network of mortgage loan originators. Belvedere Trust’s loan sourcing efforts determine the quality,
consistency and volume of loans that it purchases. Belvedere Trust targets the types and attributes of the
mortgage loans it seeks to acquire and holds these mortgage loans until a sufficient quantity has been
accumulated for securitization into high-quality mortgage-backed securities.

Our Strategy for Belvedere Trust

Operating Strategy. Our operating strategies for Belvedere Trust include:

•

targeting mortgages from high credit-quality niche segment of the first-lien jumbo, adjustable-rate and
hybrid mortgage markets, and second-lien mortgage markets, where superior risk-adjusted returns may
be available;

•

continuing to develop comprehensive mortgage investment tools and discipline to support our asset
acquisition, portfolio management and risk management activities; and

further developing the infrastructure to implement our business plan and obtaining the scaling benefits
of managing a large portfolio of whole loan assets.

We believe our strategy for Belvedere Trust currently provides it with certain competitive advantages,

including:

•

by not originating or servicing mortgages itself, Belvedere Trust limits its fixed expenses and reduces
overhead costs;

Belvedere Trust has agreements in place with a number of mortgage originators which we believe
provide Belvedere Trust with stable product sourcing while simultaneously allowing us to maintain
consistent quality controls;

Belvedere Trust securitizes large pools of mortgages and, out of the larger pools of collateral, retains
securities which have features that specifically benefit our investment strategy; and

Belvedere Trust has included in its portfolio to date primarily securities from its own securitizations.
We believe that the ability to select the mortgages that constitute collateral for the securitizations
promotes a consistent quality profile and provides Belvedere Trust with greater certainty regarding
expected performance.

Financing Strategy. Belvedere Trust leverages its capital allocated to whole-loan investment by borrowing

funds through short-term and long-term secured debt facilities. Our goal for Belvedere Trust is to use leverage
prudently, as dictated by our integrated risk management strategy, to enhance spread income and returns to
stockholders. The cornerstone of our long-term whole loan finance strategy is securitization of our whole loans.
Securitization materially limits liquidity risks and potentially maximizes risk-adjusted returns on capital.

To facilitate the financing of some of the mortgage-related assets which Belvedere Trust owns, they had in
place, at December 31, 2004, a variety of short-term borrowing arrangements, including repurchase agreements
with five dealers. At December 31, 2004, we also had three whole loan credit facilities with credit limits totaling
$850 million. When we purchase whole loans, we typically fund them through one of these warehouse facilities.
We have implemented a program to hedge select warehouse loans with Eurodollar futures contracts until they
have been priced as securities. The whole loans are kept in the warehouse facility where they earn a spread until
they are securitized.

Securitization Activities

Belvedere Trust is a qualified REIT subsidiary, but structures securitization transactions primarily through

taxable REIT subsidiaries (which generally are taxed as C corporations subject to full corporation taxation)
which in turn establish special purpose entities, or SPE, that issue securities through real estate mortgage
investment conduit, or REMIC, trusts. The principal business activity involves issuing various series of long-
term debt (in the form of pass-through certificates or bonds collateralized by residential real estate loans). The
collateral specific to each long-term debt series is the sole source of repayment of the debt and, therefore, our
exposure to loss is limited to our net investment in the collateral.

In January 2003, the Financial Accounting Standards Board, or FASB, issued FASB Interpretation No. 46,

“Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51” (FIN 46). In December 2003,
FASB issued FIN No. 46R which replaced FIN 46 and clarified ARB 51. This interpretation provides guidance
on how to identify a variable interest entity, or VIE, and when a company should include in its financial
statements the assets, liabilities and activities of a VIE. Under FIN 46, a company must consolidate a VIE when
it is considered to be its primary beneficiary. The primary beneficiary is the entity that will absorb a majority
(50% or more) of the risk of expected losses and/or receive most of the expected residual benefit from taking on
that risk. We disclose our interests in VIEs under FIN 46 in the “Investments in Residential Real Estate Loans”
footnote.

Belvedere Trust sells a portion of the mortgage-backed securities to third parties in the secondary market,
while retaining the balance. The mortgage-backed securities retained by Belvedere Trust are purchased by one of
our qualified REIT subsidiaries to maximize tax efficiency on the interest income on those securities. Belvedere
Trust has, to date, retained the majority of the subordinate securities and certain of the senior securities from its
securitizations. From its formation through December 31, 2004, Belvedere Trust had securitized a total of $2.4
billion of mortgage loans. Through December 31, 2004, mortgage-backed securities with an initial balance of
approximately $1.8 billion had been sold to third parties. The balance, $635 million of original principal, was
retained by a qualified REIT subsidiary of Belvedere Trust. Some of the securities retained by Belvedere Trust
have been financed with short-term borrowings.

On September 10, 2004, the SEC declared effective a shelf registration statement on Form S-3 filed by
Belvedere Trust’s wholly-owned direct and indirect subsidiaries, BellaVista Finance Corporation and BellaVista
Funding Corporation, as co-registrants. This registration statement registered for sale to the public up to $2
billion in asset-backed securities. On October 28, 2004, BellaVista Funding Corporation completed the first
securitization on this registration statement by issuing approximately $608.1 million of mortgage-backed
securities backed by adjustable-rate and hybrid mortgage loans. On December 17, 2004, BellaVista Funding
Corporation completed the second securitization by issuing approximately $492 million of mortgage-backed
securities backed by adjustable-rate mortgage loans. These mortgage loans were purchased by BellaVista
Funding Corporation from Belvedere Trust Finance Corporation, another of Belvedere Trust’s wholly-owned
subsidiaries.

During the three months ended March 31, 2004, Belvedere Trust transferred approximately $253.0 million
of residential mortgage loans to a securitization trust, which was a qualified SPE, pursuant to a pooling and third
party servicing agreement. During the three months ended June 30, 2004, Belvedere Trust transferred
approximately $659.0 million of residential mortgage loans in two separate transactions to securitization trusts,
which were non-qualified SPEs, pursuant to pooling and third party servicing agreements. During the three
months ended September 30, 2004, Belvedere Trust transferred approximately $391.0 million of residential
mortgage loans to a securitization trust, which was a non-qualified SPE, pursuant to a pooling and third party
servicing agreement. During the three months ended December 31, 2004, Belvedere Trust transferred
approximately $1.1 billion of residential mortgage loans in two separate transactions to securitization trusts,
which were non-qualified SPEs, pursuant to pooling and third party servicing agreements.

Management Agreement

Belvedere Trust has entered into a management agreement with BT Management Company, L.L.C., or BT

Management, a Delaware limited liability company that is owned 50% by Anworth and 50% by the executive
officers of Belvedere Trust. Pursuant to the management agreement, BT Management manages the day-to-day
operations of Belvedere Trust in exchange for an annual base management fee and a quarterly incentive fee. The
annual base management fee is equal to 1.15% of the first $300.0 million of average net invested assets, plus
0.85% of the portion above $300.0 million. The incentive fee for each fiscal quarter is equal to 20% of the
amount of net income of Belvedere Trust, before incentive compensation, for such quarter in excess of the
amount that would produce an annualized return on equity equal to the Ten-Year U.S. Treasury Rate for such
fiscal quarter plus 1%.

The management agreement requires that Belvedere Trust pay all amounts earned thereunder each quarter,
subject to offset for accrued negative incentive compensation. For the year ended December 31, 2004, Belvedere
Trust paid BT Management incentive compensation of $714,000.

Competition

When we invest in mortgage-backed securities, mortgage loans and other investment assets, we compete

with a variety of institutional investors including other REITs, insurance companies, mutual funds, pension
funds, investment banking firms, banks and other financial institutions that invest in the same types of assets.
Many of these investors have greater financial resources and access to lower costs of capital than we do.

Employees

As of December 31, 2004, Anworth had eleven employees, seven of whom were part-time, and Belvedere

Trust had six full-time employees.

Company Information

We were incorporated in Maryland on October 20, 1997 and commenced our operations on March 17, 1998.

Our principal executive offices are located at 1299 Ocean Avenue, Suite 250, Santa Monica, California, 90401.
Our telephone number is (310) 255-4493 and our fax number is (310) 434-0070.

Information on our Company Website

Our website address is www.anworth.com. We make our annual reports on Form 10-K, quarterly reports on
Form 10-Q, current reports on Form 8-K and amendments to those reports available free of charge on our website
as soon as reasonably practicable after we file these reports with the Securities and Exchange Commission. In
addition, we post the following information on our website:

•

our corporate code of conduct, which qualifies as a “code of ethics” as defined by Item 406 of
Regulation S-K of the Securities Exchange Act of 1934;

our corporate governance guidelines;

charters for our Audit Committee, Nominating and Corporate Governance Committee and
Compensation Committee;

All of the above information is also available in print upon request to our secretary at the address listed

under the heading “Company” above.

CERTAIN FEDERAL INCOME TAX CONSIDERATIONS

The following discussion summarizes particular United States federal income tax considerations regarding
our qualification and taxation as a REIT and particular United States federal income tax consequences resulting
from the acquisition, ownership and disposition of our capital stock. This discussion is based on current law and
assumes that we have qualified at all times throughout our existence, and will continue to qualify, as a REIT for
United States federal income tax purposes. The tax law upon which this discussion is based could be changed,
and any such change could have a retroactive effect. The following discussion is not exhaustive of all possible
tax considerations. This summary neither gives a detailed discussion of any state, local or foreign tax
considerations nor discusses all of the aspects of United States federal income taxation that may be relevant to
you in light of your particular circumstances or to particular types of stockholders which are subject to special tax
rules, such as insurance companies, tax-exempt entities, financial institutions or broker-dealers, foreign
corporations or partnerships, and persons who are not citizens or residents of the United States, stockholders that
hold our stock as a hedge, part of a straddle, conversion transaction or other arrangement involving more than
one position, or stockholders whose functional currency is not the United States dollar. This discussion assumes
that you will hold our capital stock as a “capital asset,” generally property held for investment, under the tax
code.

In reading the federal income tax disclosure below, it should be noted that although Anworth is combined

with all of its wholly-owned subsidiaries for financial accounting and reporting purposes, for federal income tax
purposes, only Anworth and its wholly-owned subsidiaries, Belvedere Trust Mortgage Corporation, BT
Management Holding Corporation, Belvedere Trust Secured Assets Corporation and BellaVista Finance
Corporation, constitute the REIT. Anworth’s remaining wholly-owned subsidiaries, Belvedere Trust Finance
Corporation, BT Residential Funding Corporation and BellaVista Funding Corporation, constitute a separate
consolidated group subject to regular income taxes.

We urge you to consult with your own tax advisor regarding the specific consequences to you of the
acquisition, ownership and disposition of stock in an entity electing to be taxed as a REIT, including the federal,
state, local, foreign and other tax considerations of such acquisition, ownership, disposition and election and the
potential changes in applicable tax laws.

General

Our qualification and taxation as a REIT depends upon our ability to continue to meet the various
qualification tests, imposed under the tax code and discussed below, relating to our actual annual operating
results, asset diversification, distribution levels and diversity of stock ownership. Accordingly, the actual results
of our operations for any particular taxable year may not satisfy these requirements.

We have made an election to be taxed as a REIT under the tax code commencing with our taxable year
ended December 31, 1998. We currently expect to continue operating in a manner that will permit us to maintain
our qualification as a REIT. All qualification requirements for maintaining our REIT status, however, may not
have been or will not continue to be met.

So long as we qualify for taxation as a REIT, we generally will be permitted a deduction for dividends we
pay to our stockholders. As a result, we generally will not be required to pay federal corporate income taxes on
our net income that is currently distributed to our stockholders. This treatment substantially eliminates the
“double taxation” that ordinarily results from investment in a corporation. Double taxation means taxation once
at the corporate level when income is earned and once again at the stockholder level when this income is
distributed. We will be required to pay federal income tax, however, as follows:

•

we will be required to pay tax at regular corporate rates on any undistributed “real estate investment
trust taxable income,” including undistributed net capital gain;

we may be required to pay the “alternative minimum tax” on our items of tax preference; and

•

if we have (a) net income from the sale or other disposition of “foreclosure property” which is held
primarily for sale to customers in the ordinary course of business, or (b) other non-qualifying income
from foreclosure property, we will be required to pay tax at the highest corporate rate on this income.
Foreclosure property is generally defined as property acquired through foreclosure or after a default on
a loan secured by the property or on a lease of the property.

To the extent that distributions exceed current and accumulated earnings and profits, they will constitute a

return of capital, rather than dividend or capital gain income, and will reduce the basis for the stockholder’s stock
with respect to which the distributions are paid or, to the extent that they exceed such basis, will be taxed in the
same manner as gain from the sale of that stock. For purposes of determining whether distributions are out of
current or accumulated earnings and profits, our earnings and profits will be allocated first to our preferred stock
and then to our common stock. Therefore, depending on our earnings and profits, distributions with respect to our
8.625% Series A Cumulative Preferred Stock, or our Series A Preferred Stock, (as compared to distributions with
respect to our common stock) are more likely to be treated as dividends than as return of capital or a distribution
in excess of basis.

As a result of recent changes in the tax law, dividends paid by regular C corporations to stockholders other
than corporations now are generally taxed at the rate applicable to long-term capital gains, which is a maximum
of 15%, subject to certain limitations. Because we are a REIT, however, our dividends, including dividends paid
on our Series A Preferred Stock, generally will continue to be taxed at regular ordinary income tax rates, except
in limited circumstances that we do not contemplate.

We will be required to pay a 100% tax on any net income from prohibited transactions. Prohibited

transactions are, in general, sales or other taxable dispositions of property, other than foreclosure property, held
primarily for sale to customers in the ordinary course of business. Under existing law, whether property is held as
inventory or primarily for sale to customers in the ordinary course of a trade or business depends on all the facts
and circumstances surrounding the particular transaction.

If we fail to satisfy the 75% gross income test or the 95% gross income test discussed below, but

nonetheless maintain our qualification as a REIT because certain other requirements are met, we will be subject
to a tax equal to:

•

the greater of (i) the amount by which 75% of our gross income exceeds the amount qualifying under
the 75% gross income test described below, and (ii) the amount by which 95% of our gross income
exceeds the amount qualifying under the 95% gross income test described below, multiplied by a
fraction intended to reflect our profitability.

In the event of more than de minimis failure of any of the asset tests occurs in a taxable year after 2004, as

long as the failure was due to reasonable cause and not to willful neglect and we dispose of the assets or
otherwise comply with the asset tests within six months after the last day of the quarter in which we identify such
failure, we will pay a tax equal to the greater of $50,000 or 35% of the net income from the non-qualifying assets
during the period in which we failed to satisfy any of the asset tests.

In the event of a failure to satisfy one or more requirements for REIT qualification occurring in a taxable
year after 2004, other than the gross income tests and the asset tests, as long as such failure was due to reasonable
cause and not to willful neglect, we will be required to pay a penalty of $50,000 for each such failure.

We will be required to pay a nondeductible 4% excise tax on the excess of the required distribution over the

amounts actually distributed if we fail to distribute during each calendar year at least the sum of:

•

85% of our real estate investment trust ordinary income for the year;

95% of our real estate investment trust capital gain net income for the year; and

any undistributed taxable income from prior periods.

This distribution requirement is in addition to, and different from, the distribution requirements discussed

below in the section entitled “Annual Distribution Requirements.”

We may elect to retain and pay income tax on our net long term capital gain. In that case, a United States
stockholder would be taxed on its proportionate share of our undistributed long term capital gain (to the extent
that we make a timely designation of such gain to the stockholder) and would receive a credit or refund of its
proportionate share of the tax we paid.

If we own a residual interest in a REMIC, we will be taxable at the highest corporate rate on the portion of

any excess inclusion income that we derive from the REMIC residual interests equal to the percentage of our
stock that is held by “disqualified” organizations. Although the law is unclear, similar rules may apply if we own
an equity interest in a taxable mortgage pool. To the extent that we own a REMIC residual interest in a taxable
mortgage pool through a taxable REIT subsidiary, we will not be subject to tax. A “disqualified organization”
includes:

•

the United States;

any state or political subdivision of the United States;

any foreign government;

any international organization;

any agency or instrumentality of any of the foregoing;

any other tax-exempt organization, other than a farmers’ cooperative described in Section 521 of the
Internal Revenue Code, that is exempt both from income taxation and from taxation under the
unrelated business taxable income provisions of the Internal Revenue Code; and

any rural electrical or telephone cooperative.

If we acquire any asset from a corporation which is or has been taxed as a C corporation under the tax code
in a transaction in which the basis of the asset in our hands is determined by reference to the basis of the asset in
the hands of the C corporation and we subsequently recognize gain on the disposition of the asset during the
ten-year period beginning on the date on which we acquired the asset, then we will be required to pay tax at the
highest regular corporate tax rate on this gain to the extent of the excess of:

•

the fair market value of the asset, over

our adjusted basis in the asset,

in each case determined as of the date on which we acquired the asset.

A C corporation is generally defined as a corporation required to pay full corporate-level tax. The results

described in the preceding paragraph with respect to the recognition of gain will apply unless we make an
election under Treasury Regulation Section 1.337(d)-7T(c). If such an election were made, the C corporation
would recognize taxable gain or loss as if it had sold the assets we acquired from the C corporation to an
unrelated third party at fair market value on the acquisition date.

We will be subject to a 100% excise tax if our dealings with any taxable REIT subsidiaries (defined below)

are not at arm’s length.

In addition, not withstanding our REIT status, we may also have to pay certain state and local income taxes,

because not all states and localities treat REITs in the same manner as they are treated for federal income tax
purposes.

Requirements for Qualification as a REIT

The tax code defines a REIT as a corporation, trust or association:

•

that is managed by one or more trustees or directors;

•

that issues transferable shares or transferable certificates to evidence beneficial ownership;

that would be taxable as a domestic corporation but for tax code Sections 856 through 859;

that is not a financial institution or an insurance company within the meaning of the tax code;

that is beneficially owned by 100 or more persons;

that not more than 50% in value of the outstanding stock of which is owned, actually or constructively,
by five or fewer individuals, including specified entities, during the last half of each taxable year;

that meets other tests, described below, regarding the nature of its income and assets and the amount of
its distributions; and

that elects to be a REIT or has made such election for a previous taxable year, and satisfies all relevant
filing and other administrative requirements established by the IRS that must be met to elect and retain
REIT status.

The tax code provides that all of the first four conditions stated above must be met during the entire taxable

year and that the fifth condition must be met during at least 335 days of a taxable year of twelve months, or
during a proportionate part of a taxable year of less than twelve months. The fifth and sixth conditions do not
apply until after the first taxable year for which an election is made to be taxed as a REIT.

For purposes of the sixth condition, pension trusts and other specified tax-exempt entities generally are

treated as individuals, except that a “look-through” exception generally applies with respect to pension funds.

Stock Ownership Tests

Our stock must be beneficially held by at least 100 persons, the “100 Stockholder Rule,” and no more than

50% of the value of our stock may be owned, directly or indirectly, by five or fewer individuals at any time
during the last half of the taxable year, the “5/50 Rule.” For purposes of the 100 Stockholder Rule only, trusts
described in Section 401(a) of the tax code and exempt under Section 501(a) of the tax code are generally treated
as persons. These stock ownership requirements must be satisfied in each taxable year other than the first taxable
year for which an election is made to be taxed as a REIT. We are required to solicit information from certain of
our record stockholders to verify actual stock ownership levels and our charter provides for restrictions regarding
the transfer of our stock in order to aid in meeting the stock ownership requirements. If we were to fail either of
the stock ownership tests, we would generally be disqualified from our REIT status. However, if we comply with
regulatory rules pursuant to which we are required to send annual letters to holders of our stock requesting
information regarding the actual ownership of our stock, and we do not know, or exercising reasonable diligence
would not have known, whether we failed to meet the 5/50 Rule, we will be treated as having met the 5/50 Rule.

Income Tests

We must satisfy two gross income requirements annually to maintain our qualification as a REIT:

• We must derive, directly or indirectly, at least 75% of our gross income, excluding gross income from

prohibited transactions, from specified real estate sources, including rental income, interest on
obligations secured by mortgages on real property or on interests in real property, gain from the
disposition of “qualified real estate assets,” i.e., interests in real property, mortgages secured by real
property or interests in real property, and some other assets, income from certain types of temporary
investments, amounts, such as commitment fees, receive in consideration for entering into an
agreement to make a loan secured by real property, unless such amounts are determined by income and
profits, and income derived from a REMIC in proportion to the real estate assets held by the REMIC,
unless at least 95% of the REMIC’s assets are real estate assets (in which case, all of the income
derived from the REMIC), or the “75% gross income test”; and

• We must derive at least 95% of our gross income, excluding gross income from prohibited

transactions, from (a) the sources of income that satisfy the 75% gross income test, (b) dividends,
interest and gain from the sale or disposition of stock or securities, or (c) any combination of the
foregoing, or the “95% gross income test”.

Gross income from servicing loans for third parties and loan origination fees is not qualifying income for
purposes of either gross income test. Gross income from our sale of property that we hold primarily for sale to
customers in the ordinary course of business is excluded from both the numerator and the denominator in both
income tests. Beginning with our taxable year that started on January 1, 2005, income and gain from certain
transactions that we enter into to hedge indebtedness incurred or to be incurred to acquire or carry real estate
assets and that are clearly and timely identified as such are excluded from both the numerator and denominator
for purposes of the 95% gross income test (but not the 75% gross income test).

For purposes of the 75% and 95% gross income tests, a REIT is deemed to have earned a proportionate
share of the income earned by any partnership, or any limited liability company treated as a partnership for
federal income tax purposes, in which it owns an interest, which share is determined by reference to its capital
interest in such entity, and is deemed to have earned the income earned by any qualified REIT subsidiary (in
general, a 100%-owned corporate subsidiary of a REIT). Our qualified REIT subsidiary, BT Management
Holding Corporation, a Delaware corporation, owns a 50% interest in the profits, losses and capital of BT
Management Company, L.L.C., a Delaware limited liability company which is taxed as a partnership for federal
income tax purposes. Belvedere Trust Mortgage Corporation, or Belvedere Trust, our wholly-owned mortgage
subsidiary, has entered into a management agreement with BT Management Company which manages Belvedere
Trust’s investments and performs administrative services for Belvedere Trust. So long as BT Management
Holding Corporation is a qualified REIT subsidiary of ours and it owns an interest in BT Management Company,
we will be treated, for federal income tax purposes, as directly owning BT Management Holding Corporation’s
proportionate share of the assets, liabilities and income of BT Management Company for purposes of
determining our compliance with the REIT qualification tests. Certain of BT Management Company’s gross
income (for example, management fee income under the management agreement with Belvedere Trust) will not
be qualifying income under the 75% or 95% tests described above. Accordingly, we may decide to make a
taxable REIT subsidiary election for BT Management Holding Corporation in the future if we believe that such
non-qualifying income will jeopardize our ability to satisfy the 75% or 95% income tests. If we make a taxable
REIT subsidiary election for BT Management Holding Corporation, its proportionate share of BT Management
Company’s gross income will not be treated as our gross income for purposes of our REIT qualification tests, but
BT Management Holding Corporation’s taxable income will be subject to corporate level income tax. Any
dividends paid to us by BT Management Holding Corporation while it is a taxable REIT subsidiary will be
qualifying income for purposes of our satisfaction of the 95% income test, but not the 75% test. Interest earned
by a REIT ordinarily does not qualify as income meeting the 75% or 95% gross income tests if the determination
of all or some of the amount of interest depends in any way on the income or profits of any person. Interest will
not be disqualified from meeting such tests, however, solely by reason of being based on a fixed percentage or
percentages of receipts or sales.

The following paragraphs discuss in more detail the specific application of the gross income tests to us.

Interest. The term “interest,” as defined for purposes of both gross income tests, generally excludes any

amount that is based in whole or in part on the income or profits of any person. However, interest generally
includes the following:

•

an amount that is based on a fixed percentage or percentages of receipts or sales; and

an amount that is based on the income or profits of a debtor, as long as the debtor derives substantially
all of its income from the real property securing the debt from leasing substantially all of its interest in
the property, and only to the extent that the amounts received by the debtor would be qualifying “rents
from real property” if received directly by a REIT.

If a loan contains a provision that entitles a REIT to a percentage of the borrower’s gain upon the sale of the

real property securing the loan or a percentage of the appreciation in the property’s value as of a specific date,
income attributable to that loan provision will be treated as gain from the sale of the property securing the loan,
which generally is qualifying income for purposes of both gross income tests.

Interest on debt secured by a mortgage on real property or on interests in real property, including, for this

purpose, discount points, prepayment penalties, loan assumption fees, and late payment charges that are not
compensation for services, generally is qualifying income for purposes of the 75% gross income test. However, if
the highest principal amount of a loan outstanding during a taxable year exceeds the fair market value of the real
property securing the loan as of the date the REIT agreed to originate or acquire the loan, a portion of the interest
income from such loan will not be qualifying income for purposes of the 75% gross income test, but will be
qualifying income for purposes of the 95% gross income test. The portion of the interest income that will not be
qualifying income for purposes of the 75% gross income test will be equal to the portion of the principal amount
of the loan that is not secured by real property—that is, the amount by which the loan exceeds the value of the
real estate that is security for the loan.

The interest, original issue discount, and market discount income that we receive from our mortgage loans

and mortgage-backed securities generally will be qualifying income for purposes of both gross income tests.
However, as discussed above, if the fair market value of the real estate securing any of our loans is less than the
principal amount of the loan, a portion of the income from that loan will be qualifying income for purposes of the
95% gross income test but not the 75% gross income test.

Fee Income. We may receive various fees in connection with originating mortgage loans. The fees will be

qualifying income for purposes of both the 75% and 95% income tests if they are received in consideration for
entering into an agreement to make a loan secured by real property, and the fees are not determined based on the
borrower’s income or profits. Therefore, commitment fees will generally be qualifying income for purposes of
the income tests. Other fees, such as fees received for servicing loans for third parties and origination fees, are
not qualifying income for purposes of either income test.

Dividends. Our share of any dividends received from any corporation (including any of our taxable REIT

subsidiaries, but excluding any REIT) in which we own an equity interest will qualify for purposes of the 95%
gross income test but not for purposes of the 75% gross income test. Our share of any dividends received from
any other REIT in which we own an equity interest will be qualifying income for purposes of both gross income
tests.

Rents from Real Property. We do not intend to acquire any real property, but we may acquire real property

or an interest therein in the future. To the extent that we acquire real property or an interest therein, rents we
receive will qualify as “rents from real property” in satisfying the gross income requirements for a REIT
described above only if the following conditions are met:

•

First, the amount of rent must not be based in whole or in part on the income or profits of any person.
However, an amount received or accrued generally will not be excluded from rents from real property
solely by reason of being based on fixed percentages of receipts or sales.

Second, rents we receive from a “related party tenant” will not qualify as rents from real property in
satisfying the gross income tests unless the tenant is a taxable REIT subsidiary, at least 90% of the
property is leased to unrelated tenants and the rent paid by the taxable REIT subsidiary is substantially
comparable to the rent paid by the unrelated tenants for comparable space. A tenant is a related party
tenant if the REIT, or an actual or constructive owner of 10% or more of the REIT, actually or
constructively owns 10% or more of the tenant.

Third, if rent attributable to personal property, leased in connection with a lease of real property, is
greater than 15% of the total rent received under the lease, then the portion of rent attributable to the
personal property will not qualify as rents from real property.

•

Fourth, we generally must not operate or manage our real property or furnish or render services to our
tenants, other than through an “independent contractor” who is adequately compensated and from
whom we do not derive revenue. However, we may provide services directly to tenants if the services
are “usually or customarily rendered” in connection with the rental of space for occupancy only and are
not considered to be provided for the tenants’ convenience. In addition, we may provide a minimal
amount of “non-customary” services to the tenants of a property, other than through an independent
contractor, as long as our income from the services does not exceed 1% of our income from the related
property. Furthermore, we may own up to 100% of the stock of a taxable REIT subsidiary, which may
provide customary and non-customary services to tenants without tainting its rental income from the
related properties.

Hedging Transactions. From time to time, we enter into hedging transactions with respect to one or more
of our assets or liabilities. Our hedging activities may include entering into interest rate swaps, caps, and floors,
options to purchase these items, and futures and forward contracts. Beginning with our taxable year that started
on January 1, 2005, income and gain from “hedging transactions” will be excluded from gross income for
purposes of the 95% gross income test (but not the 75% gross income test). For taxable years after 2004, a
“hedging transaction” includes any transaction entered into in the normal course of our trade or business
primarily to manage the risk of interest rate, price changes, or currency fluctuations with respect to borrowings
made or to be made, or ordinary obligations incurred or to be incurred, to acquire or carry real estate assets. We
will be required to clearly identify any such hedging transaction before the close of the day on which it was
acquired, originated, or entered into. To the extent that we hedge for other purposes, or to the extent that a
portion of our mortgage loans is not secured by “real estate assets” ( as described below under “Asset Tests”) or
in other situations, the income from those transactions is not likely to be treated as qualifying income for
purposes of the 95% gross income test. All of our hedging income and gain likely will be non-qualifying income
for purposes of the 75% gross income test. We intend to structure any hedging transactions in a manner that does
not jeopardize our status as a REIT.

Prohibited Transactions. A REIT will incur a 100% tax on the net income derived from any sale or other

disposition of property, other than foreclosure property, that the REIT holds primarily for sale to customers in the
ordinary course of a trade or business. We believe that none of our assets will be held primarily for sale to
customers and that a sale of any of our assets will not be in the ordinary course of our business. Whether a REIT
holds an asset “primarily for sale to customers in the ordinary course of a trade or business” depends, however,
on the facts and circumstances in effect from time to time, including those related to a particular asset.
Nevertheless, we will attempt to comply with the terms of a safe-harbor provisions in the federal income tax laws
prescribing when an asset sale will not be characterized as a prohibited transaction.

It is our current intention that our securitizations of our mortgage loans through our qualified REIT

subsidiaries will not be treated as sales for tax purposes. If we were to transfer mortgage loans to a REMIC, this
transfer would be treated as a sale for tax purposes and the sale may be subject to the prohibited transactions tax.
As a result, we intend to securitize our mortgage loans through our qualified REIT subsidiaries only in non-
REMIC transactions.

Foreclosure Property. We will be subject to tax at the maximum corporate rate on any income from
foreclosure property, other than income that otherwise would be qualifying income for purposes of the 75% gross
income test, less expenses directly connected with the production of that income. However, gross income from
foreclosure property will qualify under the 75% and 95% gross income tests. Foreclosure property is any real
property, including interests in real property, and any personal property incident to such real property:

•

that is acquired by a REIT as the result of the REIT having bid on such property at foreclosure, or
having otherwise reduced such property to ownership or possession by agreement or process of law,
after there was a default or default was imminent on a lease of such property or on indebtedness that
such property secured;

•

for which the related loan or lease was acquired by the REIT at a time when the default was not
imminent or anticipated; and

for which the REIT makes a proper election to treat the property as foreclosure property.

However, a REIT will not be considered to have foreclosed on a property where the REIT takes control of
the property as a mortgagee-in-possession and cannot receive any profit or sustain any loss except as a creditor of
the mortgagor. Property generally ceases to be foreclosure property at the end of the third taxable year following
the taxable year in which the REIT acquired the property, or longer if an extension is granted by the Secretary of
the Treasury. This grace period terminates and foreclosure property ceases to be foreclosure property on the first
day:

•

on which a lease is entered into for the property that, by its terms, will give rise to income that does not
qualify for purposes of the 75% gross income test, or any amount is received or accrued, directly or
indirectly, pursuant to a lease entered into on or after such day that will give rise to income that does
not qualify for purposes of the 75% gross income test;

on which any construction takes place on the property, other than completion of a building or any other
improvement, where more than 10% of the construction was completed before default became
imminent; or

which is more than 90 days after the day on which the REIT acquired the property and the property is
used in a trade or business which is conducted by the REIT, other than through an independent
contractor from whom the REIT itself does not derive or receive any income.

Failure to Satisfy Gross Income Tests.

If we fail to satisfy one or both of the gross income tests for any

taxable year, we nevertheless may qualify as a REIT for that year if we qualify for relief under certain provisions
of the federal income tax laws. Beginning with our taxable year starting January 1, 2005, those relief provisions
will be available if:

•

our failure to meet those tests is due to reasonable cause and not to willful neglect, and

following such failure for any taxable year, a schedule of the sources of our income is filed in
accordance with regulations prescribed by the Secretary of the Treasury.

We cannot predict, however, whether in all circumstance we would qualify for the relief provisions. In
addition, as discussed above, even if the relief provisions apply, we would incur a 100% tax on the gross income
attributable to the greater of the amount by which we fail the 75% gross income test or (ii) the amount by which
90% (95% beginning with our taxable year starting January 1, 2005) of our gross income exceeds the amount of
our income qualifying under the 95% gross income test, multiplied, in either case, by a fraction intended to
reflect our profitability.

Asset Tests

To qualify as a REIT, we also must satisfy the following asset tests at the end of each quarter of each

taxable year. First, at least 75% of the value of our total assets must consist of:

•

cash or cash items, including certain receivables;

government securities;

interests in real property, including leaseholds and options to acquire real property and leaseholds;

interests in mortgage loans secured by real property;

stock in other REITs;

investments in stock or debt instruments during the one-year period following our receipt of new capital
that we raise through equity offerings or public offerings of debt with at least a five-year term; and

•

regular or residual interests in a REMIC. However, if less than 95% of the assets of a REMIC consists
of assets that are qualifying real estate-related assets under the federal income tax laws, determined as
if we held such assets, we will be treated as holding directly our proportionate share of the assets of
such REMIC.

Second, of our investments not included in the 75% asset class, the value of our interest in any one issuer’s

securities may not exceed 5% of the value of our total assets.

Third, we may not own more than 10% of the voting power or value of any one issuer’s outstanding

securities.

Fourth, no more than 20% of the value of our total assets may consist of the securities of one or more

taxable REIT subsidiaries.

Fifth, no more than 25% of the value of our total assets may consist of the securities of taxable REIT
subsidiaries and other taxable subsidiaries that are not taxable REIT subsidiaries and other assets that are not
qualifying assets for purposes of the 75% asset test.

For purposes of the second and third asset tests, the term “securities” does not include stock in another
REIT, equity or debt securities of a qualified REIT subsidiary or taxable REIT subsidiary, mortgage loans that
constitute real estate assets, or equity interests in a partnership. For purposes of the 10% value test, the term
“securities” does not include:

•

“Straight debt” securities, which is defined as a written unconditional promise to pay on demand or on
a specified date a sum certain in money if (i) the debt is not convertible, directly or indirectly, into
stock, and (ii) the interest rate and interest payment dates are not contingent on profits, the borrower’s
discretion, or similar factors. “Straight debt” securities do not include any securities issued by a
partnership or a corporation in which we or any controlled taxable REIT subsidiary (i.e., a taxable
REIT subsidiary in which we own directly or indirectly more than 50% of the voting power or value of
the stock) hold non-”straight debt” securities that have aggregate value of more than 1% of the issuer’s
outstanding securities. However, “straight debt” securities include debt subject to the following
contingencies:

•

a contingency relating to the time of payment of interest or principal, as long as either (i) there is
no change to the effective yield of the debt obligation, other than a change to the annual yield that
does not exceed the greater of 0.25% or 5% of the annual yield, or (ii) neither the aggregate issue
price nor the aggregate face amount of the issuer’s debt obligations held by us exceeds $1 million
and no more than 12 months of unaccrued interest on the debt obligations can be required to be
prepaid; and

a contingency relating to the time or amount of payment upon a default or prepayment of a debt
obligation, as long as the contingency is consistent with customary commercial practice.

Any loan to an individual or an estate.

Any “section 467 rental agreement,” other than an agreement with a related party tenant.

Any obligation to pay “rents from real property.”

Certain securities issued by governmental entities.

Any security issued by a REIT.

Any debt instrument of an entity treated as a partnership for federal income tax purposes to the extent
of our interest as a partner in the partnership.

Any debt instrument of an entity treated as a partnership for federal income tax purposes not described
in the preceding bullet points if at least 75% of the partnership’s gross income, excluding income from
prohibited transaction, is qualifying income for purposes of the 75% gross income test described above
in “—Gross Income Tests.”

The asset tests described above are based on our gross assets. For federal income tax purposes, we will be

treated as owning both the loans we hold directly and the loans that we have securitized through non-REMIC
debt securitizations. Although we will have a partially offsetting obligation with respect to the securities issued
pursuant to the securitizations, these offsetting obligations will not reduce the gross assets we are considered to
own for purposes of the asset tests.

We believe that all or substantially all of the mortgage loans and mortgage-backed securities that we will

own will be qualifying assets for purposes of the 75% asset test. For purposes of these rules, however, if the
outstanding principal balance of a mortgage loan exceeds the fair market value of the real property securing the
loan, a portion of such loan likely will not be a qualifying real estate asset under the federal income tax laws.
Although the law on the matter is not entirely clear, it appears that the non-qualifying portion of that mortgage
loan will be equal to the portion of the loan amount that exceeds the value of the associated real property that is
security for that loan. To the extent that we own debt securities issued by other REITs or C corporations that are
not secured by a mortgage on real property, those debt securities will not be qualifying assets for purposes of the
75% asset test. Instead, we would be subject to the second, third and fifth asset tests with respect to those debt
securities.

We will monitor the status of our assets for purposes of the various asset tests and will seek to manage our
investment portfolio to comply at all times with such tests. There can be no assurance, however, that we will be
successful in this effort. In this regard, to determine our compliance with these requirements, we will need to
estimate the value of the real estate securing our mortgage loans at various times. Although we will seek to be
prudent in making these estimates, there can be no assurances that the IRS might not disagree with these
determinations and assert that a lower value is applicable. If we fail to satisfy the asset tests at the end of a
calendar quarter, we will not lose our REIT status if:

•

we satisfied the asset tests at the end of the preceding calendar quarter; and

the discrepancy between the value of our assets and the asset test requirements arose from changes in
the market values of our assets and was not wholly or partly caused by the acquisition of one or more
non-qualifying assets.

If we did not satisfy the condition described in the second item, above, we still could avoid disqualification

by eliminating any discrepancy within 30 days after the close of the calendar quarter in which it arose.

In the event that, at the end of any calendar quarter beginning with our taxable year that started on January

1, 2005, we violate the second or third asset tests described above, we will not lose our REIT status if (i) the
failure is de minimis (up to the lesser of 1% of our assets or $10 million) and (ii) we dispose of assets or
otherwise comply with the asset tests within six months after the last day of the quarter in which we identify such
failure. In the event of a more than de minimis failure of any of the asset tests beginning with our taxable year
that started on January 1, 2005, as long as the failure was due to reasonable cause and not to willful neglect, we
will not lose our REIT status if (i) we dispose of assets or otherwise comply with the asset tests within six
months after the last day of the quarter in which we identify such failure and (ii) pay a tax equal to the greater of
$50,000 or 35% of the net income from the non-qualifying assets during the period in which we failed to satisfy
the asset tests.

We currently believe that the loans, securities and other assets that we expect to hold will satisfy the

foregoing asset test requirements. However, no independent appraisals will be obtained to support our
conclusions as to the value of our assets and securities, or in many cases, the real estate collateral for the
mortgage loans that we hold. Moreover, the values of some assets may not be susceptible to a precise
determination. As a result, there can be no assurance that the IRS will not contend that our ownership of
securities and other assets violates one or more of the asset tests applicable to REITs.

Distribution Requirements

Each taxable year, we must distribute dividends, other than capital gain dividends and deemed distributions

of retained capital gain, to our stockholders in an aggregate amount at least equal to:

•

the sum of:

•

90% of our “REIT taxable income,” computed without regard to the dividends paid deduction and
our net capital gain or loss, and

90% of our after-tax net income, if any, from foreclosure property, minus

the sum of certain items of non-cash income.

We must pay such distributions in the taxable year to which they relate, or in the following taxable year if

we declare the distribution before we timely file our federal income tax return for the year and pay the
distribution on or before the first regular dividend payment date after such declaration.

We will pay the federal income tax on taxable income, including net capital gain, that we do not distribute
to stockholders. Furthermore, if we fail to distribute during a calendar year, or by the end of January following
the calendar year in the case of distributions with declaration and record dates falling in the last three months of
the calendar year, at least the sum of:

•

85% of our REIT ordinary income for such year,

95% of our REIT capital gain income for such year, and

any undistributed taxable income from prior periods,

we will incur a 4% nondeductible excise tax on the excess of such required distribution over the amounts we
actually distribute. We may elect to retain and pay income tax on the net long-term capital gain we receive in a
taxable year. See “—Taxation of Taxable U.S. Stockholders.” If we so elect, we will be treated as having
distributed any such retained amount for purposes of the 4% nondeductible excise tax described above. We
intend to make timely distributions sufficient to satisfy the annual distribution requirements and to avoid
corporate income tax and the 4% nondeductible excise tax.

It is possible that, from time to time, we may experience timing differences between the actual receipt of

income and actual payment of deductible expenses and the inclusion of that income and deduction of such
expenses in arriving at our REIT taxable income. Possible examples of those timing differences include the
following:

•

Because we may deduct capital losses only to the extent of our capital gains, we may have taxable
income that exceeds our economic income.

• We will recognize taxable income in advance of the related cash flow if any of our mortgage loans or
mortgage-backed securities are deemed to have original issue discount. We generally must accrue
original issue discount based on a constant yield method that takes into account projected prepayments
but that defers taking into account credit losses until they are actually incurred.

• We may recognize taxable market discount income when we receive the proceeds from the disposition

of, or principal payments on, loans that have a stated redemption price at maturity that is greater than
our tax basis in those loans, although such proceeds often will be used to make non-deductible
principal payments on related borrowings.

• We may recognize taxable income without receiving a corresponding cash distribution if we foreclose

on or make a significant modification to a loan, to the extent that the fair market value of the
underlying property or the principal amount of the modified loan, as applicable, exceeds our basis in
the original loan.

• We may recognize phantom taxable income from any residual interests in REMICs or retained
ownership interests in mortgage loans subject to collateralized mortgage obligation debt.

Although several types of non-cash income are excluded in determining the annual distribution requirement,

we will incur corporate income tax and the 4% nondeductible excise tax with respect to those non-cash income
items if we do not distribute those items on a current basis. As a result of the foregoing, we may have less cash
than is necessary to distribute all of our taxable income and thereby avoid corporate income tax and the excise
tax imposed on certain undistributed income. In such a situation, we may need to borrow funds or issue
additional common stock or preferred stock.

Under certain circumstances, we may be able to correct a failure to meet the distribution requirement for a

year by paying “deficiency dividends” to our stockholders in a later year. We may include such deficiency
dividends in our deduction for dividends paid for the earlier year. Although we may be able to avoid income tax
on amounts distributed as deficiency dividends, we will be required to pay interest to the IRS based upon the
amount of any deduction we take for deficiency dividends.

Recordkeeping Requirements

We must maintain certain records in order to qualify as a REIT. In addition, to avoid a monetary penalty, we

must request on an annual basis information from our stockholders designed to disclose the actual ownership of
our outstanding stock. We intend to comply with these requirements.

Failure to Qualify

Beginning with our taxable year that started on January 1, 2005, if we fail to satisfy one or more
requirements for REIT qualification, other than the gross income tests and the asset tests, we could avoid
disqualification if our failure is due to reasonable cause and not to willful neglect and we pay a penalty of
$50,000 for each such failure. In addition, there are relief provisions for a failure of the gross income tests and
asset tests, as described in “—Gross Income Tests” and “—Asset Tests.”

If we fail to qualify as a REIT in any taxable year, and no relief provision applies, we would be subject to

federal income tax and any applicable alternative minimum tax on our taxable income at regular corporate rates.
In calculating our taxable income in a year in which we fail to qualify as a REIT, we would not be able to deduct
amounts paid out to stockholders. In fact, we would not be required to distribute any amounts to stockholders in
that year. In such event, to the extent of our current and accumulated earnings and profits, all distributions to
stockholders would be taxable as ordinary income. Subject to certain limitations of the federal income tax laws,
corporate stockholders might be eligible for the dividends received deduction and domestic non-corporate
stockholders may be eligible for the reduced federal income tax rate of 15% on such dividends. Unless we
qualified for relief under specific statutory provisions, we also would be disqualified from taxation as a REIT for
the four taxable years following the year during which we ceased to qualify as a REIT. We cannot predict
whether in all circumstances we would qualify for such statutory relief.

Qualified REIT Subsidiaries

A qualified REIT subsidiary is any corporation in which we own 100% of such corporation’s outstanding

stock and for which no election has been made to classify it as a taxable REIT subsidiary. Belvedere Trust
Mortgage Corporation, BT Management Holding Corporation, Belvedere Trust Secured Asset Corporation and
BellaVista Finance Corporation, our wholly-owned subsidiaries, are currently treated as qualified REIT
subsidiaries. As such, their assets, liabilities, and income are generally treated as our assets, liabilities, and
income for purposes of each of the above REIT qualification tests. Belvedere Trust Mortgage Corporation may
elect to be taxed as a REIT in the future, possibly as early as its taxable year ending December 31, 2005. As
discussed above, we may decide to make an election to treat BT Management Holding Corporation as a taxable
REIT subsidiary at a future date.

Taxable REIT Subsidiaries

A taxable REIT subsidiary is any corporation in which we own stock (directly or indirectly) and which we
and such corporation elect to classify as a taxable REIT subsidiary. A taxable REIT subsidiary is not subject to

the REIT asset, income and distribution requirements, nor are its assets, liabilities, or income treated as our
assets, liabilities, or income for purposes of each of the above REIT qualification tests. Effective January 1, 2004,
we elected to treat Belvedere Trust Finance Corporation, a wholly-owned subsidiary of Belvedere Trust
Mortgage Corporation, as a taxable REIT subsidiary. Belvedere Trust Finance Corporation’s wholly-owned
subsidiaries, BT Residential Funding Corporation and BellaVista Funding Corporation, are also taxable REIT
subsidiaries. Except for Belvedere Trust Mortgage Corporation, we generally intend to make a taxable REIT
subsidiary election with respect to any other corporation in which we acquire securities constituting more than
10% by vote or value of such corporation and that is not a qualified REIT subsidiary. However, the aggregate
value of all of our taxable REIT subsidiaries must be limited to 20% of the total value of our assets.

We will be subject to a 100% penalty tax on any rent, interest, or other charges that we impose on any
taxable REIT subsidiary in excess of an arm’s length price for comparable services. We expect that any rents,
interest, or other charges imposed on any taxable REIT subsidiary will be at arm’s length prices.

We generally expect to derive income from our taxable REIT subsidiaries by way of dividends. Such
dividends are not real estate source income for purposes of the 75% income test. Therefore, when aggregated
with our non-real estate source income, such dividends must be limited to 25% of our gross income each year.
We will monitor the value of our investment in, and the distributions from, our taxable REIT subsidiaries to
ensure compliance with all applicable REIT income and asset tests.

Taxable REIT subsidiaries are generally subject to corporate level tax on their net income and will generally

be able to distribute only net after-tax earnings to its stockholders, including us, as dividend distributions.

Taxation of Taxable United States Stockholders

For purposes of the discussion in this Form 10-K, the term “United States stockholder” means a holder of

our stock that is, for United States federal income tax purposes:

•

a citizen or resident of the United States;

a corporation (including an entity treated as a corporation for federal income tax purposes), partnership,
or other entity created or organized in or under the laws of the United States or of any state thereof or
in the District of Columbia, unless Treasury regulations provide otherwise;

an estate the income of which is subject to United States federal income taxation regardless of its
source; or

a trust (i) whose administration is subject to the primary supervision of a United States court and which
has one or more United States persons who have the authority to control all substantial decisions of the
trust or (ii) that has a valid election in place to be treated as a United States person.

Distributions Generally

Distributions out of our current or accumulated earnings and profits, other than capital gain dividends, will
generally be taxable to United States stockholders as ordinary income. Provided that we continue to qualify as a
REIT, dividends paid by us will not be eligible for the dividends received deduction generally available to United
States stockholders that are corporations. To the extent that we make distributions in excess of current and
accumulated earnings and profits, the distributions will be treated as a tax-free return of capital to each United
States stockholder and will reduce the adjusted tax basis which each United States stockholder has in our stock
by the amount of the distribution, but not below zero. Distributions in excess of a United States stockholder’s
adjusted tax basis in its stock will be taxable as capital gain and will be taxable as long-term capital gain if the
stock has been held for more than one year. If we declare a dividend in October, November, or December of any
calendar year which is payable to stockholders of record on a specified date in such a month and actually pay the
dividend during January of the following calendar year, the dividend is deemed to be paid by us and received by

the stockholder on December 31st of the previous year, but only to the extent we have any remaining
undistributed earnings and profits (as computed under the tax code) as of December 31st. Any portion of this
distribution in excess of our previously undistributed earnings and profits as of December 31st should be treated
as a distribution to our stockholders in the following calendar year for United States federal income tax purposes.
Stockholders may not include in their own income tax returns any of our net operating losses or capital losses.
Ordinary dividends to a United States stockholder generally will not qualify for the 15% tax rate for “qualified
dividend income.” However, the 15% tax rate for “qualified dividend income” will apply to our ordinary REIT
dividends (i) attributable to dividends received by us from non-REIT corporations such as a taxable REIT
subsidiary, and (ii) any income on which we have paid a corporate income tax.

Capital Gain Distributions

Distributions designated by us as capital gain dividends will be taxable to United States stockholders as
capital gain income. We can designate distributions as capital gain dividends to the extent of our net capital gain
for the taxable year of the distribution. This capital gain income will generally be taxable to non-corporate United
States stockholders at a 15% or 25% rate based on the characteristics of the asset we sold that produced the gain.
United States stockholders that are corporations may be required to treat up to 20% of certain capital gain
dividends as ordinary income.

Retention of Net Capital Gains

We may elect to retain, rather than distribute as a capital gain dividend, our net capital gains. If we were to

make this election, we would pay tax on such retained capital gains. In such a case, our stockholders would
generally:

•

include their proportionate share of our undistributed net capital gains in their taxable income;

receive a credit for their proportionate share of the tax paid by us in respect of such net capital gain;
and

increase the adjusted basis of their stock by the difference between the amount of their share of our
undistributed net capital gain and their share of the tax paid by us.

Passive Activity Losses, Investment Interest Limitations and Other Considerations of Holding Our Stock

Distributions we make and gains arising from the sale or exchange of our stock by a United States

stockholder will not be treated as passive activity income. As a result, United States stockholders will not be able
to apply any “passive losses” against income or gains relating to our stock. Distributions by us, to the extent they
do not constitute a return of capital, generally will be treated as investment income for purposes of computing the
investment interest limitation under the tax code. Further, if we, or a portion of our assets, were to be treated as a
taxable mortgage pool, any excess inclusion income that is allocated to you could not be offset by any losses or
other deductions you may have.

Dispositions of Stock

A United States stockholder that sells or disposes of our stock will recognize gain or loss for federal income

tax purposes in an amount equal to the difference between the amount of cash or the fair market value of any
property the stockholder receives on the sale or other disposition and the stockholder’s adjusted tax basis in the
stock. This gain or loss will be capital gain or loss and will be long-term capital gain or loss if the stockholder
has held the stock for more than one year. In general, any loss recognized by a United States stockholder upon
the sale or other disposition of our stock that the stockholder has held for six months or less will be treated as
long-term capital loss to the extent the stockholder received distributions from us which were required to be
treated as long-term capital gains. All or a portion of any loss that a United States stockholder realizes upon a
taxable disposition of our common stock may be disallowed if the stockholder purchases other stock within 30
days before or after the disposition.

Information Reporting and Backup Withholding

We report to our United States stockholders and the IRS the amount of dividends paid during each calendar

year and the amount of any tax withheld. Under the backup withholding rules, a stockholder may be subject to
backup withholding with respect to dividends paid and redemption proceeds unless the holder is a corporation or
comes within other exempt categories and, when required, demonstrates this fact, or provides a taxpayer
identification number or social security number, certifying as to no loss of exemption from backup withholding,
and otherwise complies with applicable requirements of the backup withholding rules. A United States
stockholder that does not provide us with its correct taxpayer identification number or social security number
may also be subject to penalties imposed by the IRS. A United States stockholder can meet this requirement by
providing us with a correct, properly completed and executed copy of IRS Form W-9 or a substantially similar
form. Backup withholding is not an additional tax. Any amount paid as backup withholding will be creditable
against the stockholder’s income tax liability, if any, and otherwise be refundable. In addition, we may be
required to withhold a portion of capital gain distributions made to any stockholders who fail to certify their non-
foreign status.

Taxation of Tax-Exempt Stockholders

The IRS has ruled that amounts distributed as a dividend by a REIT will be treated as a dividend by the
recipient and excluded from the calculation of unrelated business taxable income, or UBTI, when received by a
tax-exempt entity. Based on that ruling, provided that a tax-exempt stockholder has not held our stock as “debt
financed property” within the meaning of the tax code, i.e., property, the acquisition, or holding of which is
financed through a borrowing by the tax-exempt United States stockholder, the stock is not otherwise used in an
unrelated trade or business, and we or Belvedere Trust Mortgage Corporation do not hold a residual interest in a
real estate mortgage investment conduit, or REMIC, that gives rise to “excess inclusion” income, as defined in
Section 860E of the tax code, dividend income on our stock and income from the sale of our stock should not be
unrelated business taxable income to a tax-exempt stockholder. However, if we or Belvedere Trust Mortgage
Corporation were to hold residual interests in a REMIC, or if we or a pool of our assets or Belvedere Trust
Mortgage Corporation’s assets were to be treated as a “taxable mortgage pool,” a portion of the dividends paid to
a tax-exempt stockholder may be subject to tax as unrelated business taxable income. Although we do not believe
that we, or any portion of our assets or Belvedere Trust Mortgage Corporation’s assets, will be treated as a
taxable mortgage pool, no assurance can be given that the IRS might not successfully maintain that such a
taxable mortgage pool exists.

For tax-exempt stockholders that are social clubs, voluntary employee benefit associations, supplemental
unemployment benefit trusts, and qualified group legal services plans exempt from federal income taxation under
Sections 501(c)(7), (c)(9), (c)(17) and (c)(20) of the tax code, respectively, income from an investment in our
stock will constitute unrelated business taxable income unless the organization is able to properly claim a
deduction for amounts set aside or placed in reserve for certain purposes so as to offset the income generated by
its investment in our stock. Any prospective and current investors should consult their tax advisors concerning
these “set aside” and reserve requirements.

Notwithstanding the above, however, a substantial portion of the dividends you receive may constitute

UBTI if we are treated as a “pension-held REIT” and you are a pension trust which:

•

is described in Section 401(a) of the tax code; and

holds more than 10%, by value, of the interests in the REIT.

Tax-exempt pension funds that are described in Section 401(a) of the tax code and exempt from tax under

Section 501(a) of the tax code are referred to below as “qualified trusts.”

A REIT is a “pension-held REIT” if:

•

it would not have qualified as a REIT but for the fact that Section 856(h)(3) of the tax code provides
that stock owned by a qualified trust shall be treated, for purposes of the 5/50 Rule, described above, as
owned by the beneficiaries of the trust, rather than by the trust itself; and

either at least one qualified trust holds more than 25%, by value, of the interests in the REIT, or one or
more qualified trusts, each of which owns more than 10%, by value, of the interests in the REIT, holds
in the aggregate more than 50%, by value, of the interests in the REIT.

The percentage of any REIT dividend treated as unrelated business taxable income is equal to the ratio of:

•

the unrelated business taxable income earned by the REIT, less directly related expenses, treating the
REIT as if it were a qualified trust and therefore subject to tax on unrelated business taxable income, to

the total gross income, less directly related expenses, of the REIT.

A de minimis exception applies where the percentage is less than 5% for any year. As a result of the
limitations on the transfer and ownership of stock contained in our charter, we do not expect to be classified as a
“pension-held REIT.”

Taxation of Non-United States Stockholders

The rules governing federal income taxation of “non-United States stockholders” are complex and no
attempt will be made herein to provide more than a summary of these rules. “Non-United States stockholders”
means beneficial owners of shares of our stock that are not United States stockholders (as such term is defined in
the discussion above under the heading entitled “Taxation of Taxable United States Stockholders”).

PROSPECTIVE AND CURRENT NON-UNITED STATES STOCKHOLDERS SHOULD
CONSULT THEIR TAX ADVISORS TO DETERMINE THE IMPACT OF FOREIGN, FEDERAL,
STATE AND LOCAL INCOME TAX LAWS WITH REGARD TO AN INVESTMENT IN OUR STOCK
AND OF OUR ELECTION TO BE TAXED AS A REAL ESTATE INVESTMENT TRUST, INCLUDING
ANY REPORTING REQUIREMENTS.

Distributions to non-United States stockholders that are not attributable to gain from our sale or exchange of

United States real property interests, and that are not designated by us as capital gain dividends or retained
capital gains, will be treated as dividends of ordinary income to the extent that they are made out of our current
or accumulated earnings and profits. These distributions will generally be subject to a withholding tax equal to
30% of the distribution unless an applicable tax treaty reduces or eliminates that tax. However, if income from an
investment in our stock is treated as effectively connected with the non-United States stockholder’s conduct of a
United States trade or business, the non-United States stockholder generally will be subject to federal income tax
at graduated rates in the same manner as United States stockholders are taxed with respect to those distributions,
and also may be subject to the 30% branch profits tax in the case of a non-United States stockholder that is a
corporation. We expect to withhold tax at the rate of 30% on the gross amount of any distributions made to a
non-United States stockholder unless:

•

a lower treaty rate applies and any required form, for example IRS Form W-8BEN, evidencing
eligibility for that reduced rate is filed by the non-United States stockholder with us; or

the non-United States stockholder files an IRS Form W-8ECI with us claiming that the distribution is
effectively connected income.

Any portion of the dividends paid to non-United States stockholders that is treated as excess inclusion

income will not be eligible for exemption from the 30% withholding tax or a reduced treaty rate.

Distributions in excess of our current and accumulated earnings and profits will not be taxable to non-

United States stockholders to the extent that these distributions do not exceed the adjusted basis of the

stockholder’s stock, but rather will reduce the adjusted basis of that stock. To the extent that distributions in
excess of current and accumulated earnings and profits exceed the adjusted basis of a non-United States
stockholder’s stock, these distributions will give rise to tax liability if the non-United States stockholder would
otherwise be subject to tax on any gain from the sale or disposition of its stock, as described below. Because it
generally cannot be determined at the time a distribution is made whether or not such distribution may be in
excess of current and accumulated earnings and profits, the entire amount of any distribution normally will be
subject to withholding at the same rate as a dividend. However, amounts so withheld are creditable against
United States tax liability, if any, or refundable by the IRS to the extent the distribution is subsequently
determined to be in excess of our current and accumulated earnings and profits. We are also required to withhold
10% of any distribution in excess of our current and accumulated earnings and profits if our stock is a United
States real property interest because we are not a domestically controlled REIT, as discussed below.
Consequently, although we intend to withhold at a rate of 30% on the entire amount of any distribution, to the
extent that we do not do so, any portion of a distribution not subject to withholding at a rate of 30% may be
subject to withholding at a rate of 10%.

Distributions attributable to our capital gains which are not attributable to gain from the sale or exchange of

a United States real property interest generally will not be subject to income taxation, unless (1) investment in
our stock is effectively connected with the non-United States stockholder’s U.S. trade or business (or, if an
income tax treaty applies, is attributable to a U.S. permanent establishment of the non-United States stockholder),
in which case the non-United States stockholder will be subject to the same treatment as United States
stockholders with respect to such gain (except that a corporate non-United States stockholder may also be subject
to the 30% branch profits tax), or (2) the non-United States stockholder is a non-resident alien individual who is
present in the United States for 183 days or more during the taxable year and certain other conditions are
satisfied, in which case the non-resident alien individual will be subject to a 30% tax on the individual’s capital
gains.

For any year in which we qualify as a REIT, distributions that are attributable to gain from the sale or
exchange of a United States real property interest, which includes some interests in real property, but generally
does not include an interest solely as a creditor in mortgage loans or mortgage-backed securities, will be taxed to
a non-United States stockholder under the provisions of the Foreign Investment in Real Property Tax Act of
1980, or FIRPTA. Under FIRPTA, distributions attributable to gain from sales of United States real property
interests are taxed to a non-United States stockholder as if that gain were effectively connected with the
stockholder’s conduct of a United States trade or business. Non-United States stockholders thus would be taxed
at the normal capital gain rates applicable to stockholders, subject to applicable alternative minimum tax and a
special alternative minimum tax in the case of nonresident alien individuals. Distributions subject to FIRPTA
also may be subject to the 30% branch profits tax in the hands of a non-United States corporate stockholder. We
are required to withhold 35% of any distribution that we designate (or, if greater, the amount that we could
designate) as a capital gains dividend. The amount withheld is creditable against the non-United States
stockholder’s FIRPTA tax liability.

Beginning with our tax year starting January 1, 2005, a capital gain distribution from a REIT to a foreign
investor has been removed from the category of effectively connected income, provided that (i) the distribution is
received with respect to a class of stock that is regularly traded on an established securities market located in the
United States (our stock currently is so traded) and (ii) the foreign investor does not own more than 5% of the
class of stock at any time during the taxable year within which the distribution is received. In that case, the
foreign investor is not required to file a U.S. federal income tax return by reason of receiving such a distribution.
The distribution is to be treated as a REIT dividend to that investor, taxed as a REIT dividend that is not a capital
gain. Also, the branch profits tax does not apply to such a distribution.

Gains recognized by a non-United States stockholder upon a sale of our stock generally will not be taxed
under FIRPTA if we are a domestically-controlled REIT, which is a REIT in which at all times during a specified
testing period less than 50% in value of the stock was held directly or indirectly by non-United States

stockholders. Because our stock is publicly traded, we cannot assure our investors that we are or will remain a
domestically-controlled REIT. Even if we are not a domestically-controlled REIT, however, a non-United States
stockholder that owns, actually or constructively, 5% or less of our stock throughout a specified testing period
will not recognize taxable gain on the sale of our stock under FIRPTA if the shares are traded on an established
securities market.

If gain from the sale of the stock were subject to taxation under FIRPTA, the non-United States stockholder

would be subject to the same treatment as United States stockholders with respect to that gain, subject to
applicable alternative minimum tax, a special alternative minimum tax in the case of nonresident alien
individuals, and the possible application of the 30% branch profits tax in the case of non-United States
corporations. In addition, the purchaser of the stock could be required to withhold 10% of the purchase price and
remit such amount to the IRS.

Gains not subject to FIRPTA will be taxable to a non-United States stockholder if:

•

the non-United States stockholder’s investment in the stock is effectively connected with a trade or
business in the United States, in which case the non-United States stockholder will be subject to the
same treatment as United States stockholders with respect to that gain; or

the non-United States stockholder is a nonresident alien individual who was present in the United
States for 183 days or more during the taxable year and other conditions are met, in which case the
nonresident alien individual will be subject to a 30% tax on the individual’s capital gains.

Information Reporting and Backup Withholding

If the proceeds of a disposition of our stock are paid by or through a U.S. office of a broker-dealer, the
payment is generally subject to information reporting and to backup withholding (currently at a rate of 28%)
unless the disposing non-United States stockholder certifies as to his name, address and non-U.S. status or
otherwise establishes an exemption. Generally, U.S. information reporting and backup withholding will not apply
to a payment of disposition proceeds if the payment is made outside the U.S. through a foreign office of a foreign
broker-dealer. If the proceeds from a disposition of our stock are paid to or through a foreign office of a U.S.
broker-dealer or a non-U.S. office of a foreign broker-dealer that is (i) a “controlled foreign corporation” for
federal income tax purposes, (ii) a foreign person 50% or more of whose gross income from all sources for a
three-year period was effectively connected with a U.S. trade or business, (iii) a foreign partnership with one or
more partners who are U.S. persons and who in the aggregate hold more than 50% of the income or capital
interest in the partnership, or (iv) a foreign partnership engaged in the conduct of a trade or business in the
United States, then (i) backup withholding will not apply unless the broker-dealer has actual knowledge that the
owner is not a foreign stockholder, and (ii) information reporting will not apply if the non-United States
stockholder satisfies certification requirements regarding its status as a foreign stockholder.

State, Local and Foreign Taxation

We may be required to pay state, local and foreign taxes in various state, local and foreign jurisdictions,
including those in which we transact business or make investments, and our stockholders may be required to pay
state, local and foreign taxes in various state, local and foreign jurisdictions, including those in which they reside.
Our state, local and foreign tax treatment may not conform to the federal income tax consequences summarized
above. In addition, a stockholder’s state, local and foreign tax treatment may not conform to the federal income
tax consequences summarized above. Consequently, prospective investors should consult their tax advisors
regarding the effect of state, local and foreign tax laws on an investment in our stock.

Possible Legislative or Other Actions Affecting Tax Considerations

Prospective investors and stockholders should recognize that the present U.S. federal income tax treatment

of an investment in our stock may be modified by legislative, judicial or administrative action at any time and

that any such action may affect investments and commitments previously made. The rules dealing with U.S.
federal income taxation are constantly under review by persons involved in the legislative process and by the
Internal Revenue Service and the U.S. Treasury Department, resulting in revisions of regulations and revised
interpretations of established concepts as well as statutory changes. Revisions in U.S. federal tax laws and
interpretations thereof could adversely affect the tax consequences of an investment in our stock.

Item 2. PROPERTY

We sublease approximately 5,500 square feet of office space in Santa Monica, California under a sublease

agreement with Pacific Income Advisers, Inc. that expires in 2012. Belvedere Trust subleases approximately
2,300 square feet of office space in San Francisco, California, under an agreement with Keefe, Bruyette and
Woods, Inc. that expires July 31, 2008.

Item 3. LEGAL PROCEEDINGS

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

Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted to a vote of security holders during the quarter ended December 31, 2004.

PART II

Item 5. MARKET FOR REGISTRANT’S PREFERRED EQUITY, COMMON EQUITY AND

RELATED STOCKHOLDER MATTERS

Market Information

Our Series A Preferred Stock began trading under the symbol ANHPrA on the New York Stock Exchange
on November 8, 2004. The high and low sale prices for our preferred stock, as reported by the New York Stock
Exchange, during the year ended December 31, 2004 are as follows:

2004

High

Low

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
First Quarter
Second Quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Third Quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Fourth Quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ — $ —
$ — $ —
$ — $ —
$24.60
$25.05

Our Common Stock began trading under the symbol ANH on the New York Stock Exchange on May 9,
2003. Our common stock previously traded under the symbol ANH on the American Stock Exchange. Preceding
March 17, 1998, there had been no public market for our common stock. The high and low sale prices for our
common stock, as reported by the American and New York Stock Exchanges, for the periods indicated are as
follows:

First Quarter
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Second Quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Third Quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Fourth Quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$13.13
$15.65
$16.55
$15.19

$11.41
$13.00
$13.70
$12.93

$14.28
$14.05
$12.15
$11.49

$13.35
$10.06
$10.04
$10.19

2003

2004

High

Low

High

Low

Holders

As of March 14, 2005 there were approximately 11 record holders of our Series A Preferred Stock. On

March 14, 2005, the last reported sale price of our Series A Preferred Stock on the New York Stock Exchange
was $25.49 per share. As of March 14, 2005 there were approximately 1,568 record holders of our Common
Stock. On March 14, 2005, the last reported sale price of our Common Stock on the New York Stock Exchange
was $9.60 per share.

Dividends

We pay cash dividends on a quarterly basis. The following table lists the cash dividends declared on each

share of our Series A Preferred Stock for 2004 and on each share of our Common Stock for our most recent two
fiscal years. The dividends listed below were based primarily on the board of directors’ evaluation of earnings
and consideration of actions necessary to maintain our REIT status for each listed quarter and were declared on
the date indicated:

Cash Dividends
Per
Preferred Share

Cash Dividends
Per
Common Share

2003

2004

First Quarter ended March 31, 2003 . . . . . . . . . . . . . .
Second Quarter ended June 30, 2003 . . . . . . . . . . . . . .
Third Quarter ended September 30, 2003 . . . . . . . . . .
. . . . . . .
Fourth Quarter ended December 31, 2003(1)

$
$
$
$

—
—
—
—

First Quarter ended March 31, 2004 . . . . . . . . . . . . . .
Second Quarter ended June 30, 2004 . . . . . . . . . . . . . .
Third Quarter ended September 30, 2004 . . . . . . . . . .
. . . . . . .
Fourth Quarter ended December 31, 2004(2)

—
$
—
$
$
—
$0.335417

$0.45
$0.45
$0.33
$0.33

$0.38
$0.33
$0.27
$0.27

Cash Dividends
Per Common Share

Date Dividends
Declared

April 16, 2003
July 17, 2003
October 15, 2003
December 17, 2003

April 12, 2004
July 2, 2004
October 13, 2004
December 15, 2004

(1) The common stock dividend was paid on January 27, 2004 to holders of record as of the close of business

on December 31, 2003.

(2) The Series A Preferred Stock dividend was paid on January 18, 2005 to holders of record as of the close of
business on December 31, 2004. The Common Stock dividend was paid on January 27, 2005 to holders of
record as of the close of business on December 31, 2004.

Equity Compensation Plan Information

The following table provides information as of December 31, 2004 with respect to our common shares

issuable under our 2004 Equity Compensation Plan:

(a) Number of
securities to be
issued upon
exercise of
outstanding
options, warrants
and rights

(b) Weighted-
average exercise
price of
outstanding
options, warrants
and rights

(c) Number of
securities
remaining
available for
future issuance
under equity
compensation
plans (excluding
securities
reflected in
column (a))

Plan Category

Equity compensation plans approved by security

holders(1)

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1,383,670

$12.042

1,639,804

Equity compensation plans not approved by security

holders(2)

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

N/A

Total

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1,383,670

$12.042

1,639,804

(1)

In May 2004, our stockholders adopted the Anworth Mortgage Asset Corporation 2004 Equity
Compensation Plan which amended and restated our 1997 Stock Option and Awards Plan. The plan
authorized the board of directors or a committee of our board to grant options to purchase of up to 3,500,000
of the outstanding shares of our common stock. The plan does not provide for automatic annual increases in
the aggregate share reserve or the number of shares remaining available for grant.

(2) The Company has not authorized the issuance of its equity securities under any plan not approved by

security holders.

Item 6. SELECTED FINANCIAL DATA

The selected financial data as of December 31, 2004 and 2003 and for the years ended December 31, 2004,

Consolidated Statements of Income Data

Year Ended December 31,

2000

2001

2002

2003

2004

(amounts in thousands, except per share data)

Days in period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interest income net of amortization of premium and discount
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

366
. . . $10,314 $10,768 $ 66,855 $100,077 $ 163,023
(97,949)

(45,661)

(29,576)

(6,363)

(8,674)

365

366

365

Net interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Gain on sales of securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net gain on derivative instruments . . . . . . . . . . . . . . . . . . . . . . . .
Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Income from operations before minority interest
. . . . . . . . . . . . .
Minority interest in net income of a subsidiary . . . . . . . . . . . . . . .

1,640
—
—
(379)

1,261
—

4,405
430
—
(1,129)

3,706
—

37,279
4,709
—
(10,318)

31,670
—

54,416
3,497
—
(7,718)

50,195
—

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,261 $ 3,706 $ 31,670 $ 50,195 $
Dividend on preferred stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ — $ — $ — $ — $

65,074
259
340
(9,575)

56,098
(293)

55,805
(369)

Net income available to common stockholders . . . . . . . . . . . . . . . $ 1,261 $ 3,706 $ 31,670 $ 50,195 $

55,436

Basic earnings per share available to common stockholders . . . . $

0.54 $

1.52 $

1.81 $

1.52 $

1.23

Average number of shares outstanding . . . . . . . . . . . . . . . . . . . . .

2,331

2,442

17,461

32,927

45,244

Diluted earnings per share available to common stockholders . . . $

0.54 $ 1.50 $

1.80 $

1.52 $

1.22

Average number of diluted shares outstanding . . . . . . . . . . . . . . .

2,331

2,467

17,591

33,112

45,329

Preferred Stock dividends declared per share . . . . . . . . . . . . . . . . $ — $ — $ — $ — $0.335417

Common Stock dividends declared per share(1) . . . . . . . . . . . . . . $

0.40 $

1.64 $

2.00 $

1.56 $

1.25

Consolidated Balance Sheets Data

At December 31,

2000

2001

2002

2003

2004

(amounts in thousands, except per share data)

Agency mortgage-backed securities, net . . . . . . . . . . . . . . $134,889 $420,214 $2,430,103 $4,245,853 $4,588,541
Residential real estate loans . . . . . . . . . . . . . . . . . . . . . . . . $ — $ — $
— $2,628,334
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $141,834 $424,610 $2,443,884 $4,263,274 $7,319,070
Repurchase agreements . . . . . . . . . . . . . . . . . . . . . . . . . . . $121,891 $325,307 $2,153,870 $3,775,691 $4,717,436
— $ 556,233
Whole loan financing facilities . . . . . . . . . . . . . . . . . . . . . $ — $ — $
Mortgage-backed securities issued . . . . . . . . . . . . . . . . . . $ — $ — $
— $1,494,851
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $123,633 $369,613 $2,178,362 $3,805,877 $6,811,803
Stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 18,201 $ 54,997 $ 265,522 $ 457,397 $ 507,036
46,497
Number of common shares outstanding . . . . . . . . . . . . . .
10.31
Book value per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $

25,346
10.48 $

42,707
10.71 $

6,951
7.91 $

2,350
7.75 $

— $
— $

— $

(1) On September 26, 2000, our board of directors announced that, beginning with the third quarter of 2000,

dividends would generally be declared after each quarter-end rather than during the applicable quarter.

Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

The following discussion should be read in conjunction with our financial statements included elsewhere in

this Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties. Our
actual results could differ materially from those anticipated in these forward-looking statements as a result of
various factors including those set forth under “Risk Factors” herein.

General

We were formed in October 1997 to invest primarily in mortgage-related assets including mortgage pass-

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

We are organized for tax purposes as a REIT. Accordingly, we generally distribute substantially all of our

earnings to stockholders without paying federal or state income tax at the corporate level on the distributed
earnings. As of December 31, 2004, our qualified REIT assets (real estate assets, as defined in the tax code, cash
and cash items and government securities) were greater than 90% of our total assets, as compared to the tax code
requirement that at least 75% of our total assets must be qualified REIT assets. Greater than 99% of our 2004
revenue qualifies for both the 75% source of income test and the 95% source of income test under the REIT
rules. We believe we met all REIT requirements regarding the ownership of our common stock and the
distributions of our net income. Therefore, we believe that we continue to qualify as a REIT under the provisions
of the tax code.

From the time of our inception through June 13, 2002, we were externally managed by Anworth Mortgage
Advisory Company, or the manager, pursuant to a management agreement. As an externally managed company,
we had no employees of our own and relied on the manager to conduct our business and operations. On June 13,
2002, the manager merged with and into our company. The merger was approved by a special committee
consisting solely of our independent directors, our full board of directors and the vote of a majority of our
stockholders. Upon the closing of the merger, the management agreement terminated.

The market value of our common stock issued, valued as of the consummation of the merger, in excess of

the fair value of the net tangible assets acquired has been accounted for as a non-cash charge to operating
income. Since we did not acquire tangible net assets from the manager in the merger, the non-cash charge
equaled the value of the consideration paid in the merger, which was approximately $3.2 million. This non-cash
charge did not reduce our taxable income, of which at least 90% must be paid as dividends to stockholders to
maintain our status as a REIT. It did, however, reduce our reportable net income. In addition, we incurred
$295,000 in merger-related expenses.

On November 3, 2003, we formed a wholly-owned subsidiary called Belvedere Trust Mortgage

issue securities through real estate mortgage investment conduit, or REMIC, trusts. Since its formation,
Belvedere Trust has become an increasingly important part of our overall operations and, as of December 31,
2004, Belvedere Trust’s assets comprised 37% of our overall assets. Through December 31, 2004, we had made
an investment of approximately $96 million in Belvedere Trust to capitalize its mortgage operations.

In January 2003, the Financial Accounting Standards Board, or FASB, issued FASB Interpretation No. 46,

Belvedere Trust, through taxable REIT subsidiaries, acquires mortgage loans from various suppliers of
mortgage-related assets throughout the United States, including savings and loan associations, banks, mortgage
bankers and other mortgage lenders. Belvedere Trust may acquire mortgage loans directly from originators and
from entities holding mortgage loans originated by others. Belvedere Trust has built relationships with and
continues to expand upon a diversified network of mortgage loan originators. Belvedere Trust’s loan sourcing
efforts determine the quality, consistency and volume of loans that it purchases. Belvedere Trust targets the types
and attributes of the mortgage loans it seeks to acquire and holds these mortgage loans until a sufficient quantity
has been accumulated for securitization into high-quality mortgage-backed securities.

At December 31, 2004, we had total assets of $7.3 billion. Our portfolio consisted of $4.6 billion of agency

Results of Operations

Years Ended December 31, 2004 and 2003

For the year ended December 31, 2004, our net income was $55,805,000, or $1.22 per diluted share
available to common stockholders, based on an average of 45,329,000 shares outstanding. For the year ended
December 31, 2003, our net income was $50,195,000, or $1.52 per diluted share available to common
stockholders, based on an average of 33,112,000 shares outstanding.

Net interest income for the year ended December 31, 2004 totaled $65,074,000, or 39.9% of total interest
income, compared to $54,416,000, or 54.4% of total interest income, for the year ended December 31, 2003. Net
interest income is comprised of the interest income earned on mortgage investments less interest expense from
borrowings. Interest income net of premium amortization expense for the year ended December 31, 2004 was
$163,023,000, compared to $100,077,000 for the year ended December 31, 2003, an increase of 62.9%. Interest
expense for the year ended December 31, 2004 was $97,949,000, compared to $45,661,000 for the year ended
December 31, 2003, an increase of 114.5%. As a result of investing the proceeds of our common and preferred
stock offerings, our assets and borrowings and the related interest income and interest expense have increased
significantly during the year. Although the amortized cost of Anworth’s agency mortgage-backed securities
increased by 8.5%, from $4.25 billion to $4.61 billion, the large increase in our mortgage-related assets and
borrowings was due to the growth of Belvedere Trust, our wholly-owned subsidiary. Belvedere Trust, which was
formed in November 2003, now represents approximately 37% of our total assets. The larger percentage increase
in interest expense was due primarily to the increase in interest rates during the year.

Premium amortization expense for Anworth increased $8,685,000, or 22%, from $38,934,000 to

$47,619,000, and it was $3,784,000 for Belvedere Trust, during the year ended December 31, 2004 due to the
increase in assets. During the year ended December 31, 2003, the increase in premium amortization expense
resulted from an increase in the constant prepayment rate of our agency mortgage-backed securities resulting
primarily from an extremely high volume of mortgage refinancings driven by record-low interest rates. These
refinancings occurred mainly in the second quarter of 2003 and their net effect was realized through the increase
in premium amortization expense in the third quarter of 2003.

The table below shows the approximate constant prepayment rate of our agency mortgage-backed securities:

2004 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

27%
35%

42%
40%

36%
46%

29%
32%

First
Quarter

Second
Quarter

Third
Quarter

Fourth
Quarter

During the year ended December 31, 2004, we realized a gain on sale of securities of $259,000, or 0.2% of
total interest income, compared to $3,497,000, or 3.5% of total interest income, during the year ended December
31, 2003. During the year ended December 31, 2004, we also realized a net gain on derivative instruments of
$340,000, or 0.2% of total interest income, and we did not have any gain or loss on these instruments during the
year ended December 31, 2003.

Total expenses were $9,575,000 for the year ended December 31, 2004, compared to $7,718,000 for the
year ended December 31, 2003. The increase of $1,857,000 in total expenses was due primarily to an increase in
compensation and benefit expenses of $786,000 (due primarily to staffing at Belvedere Trust and an increase in
salaries at the Company), an increase in the provision for loan losses of $591,000 (relating to the residential real
estate loans at Belvedere Trust) and an increase in other expense of $1,423,000, partially offset by a decrease in
incentive compensation expense of $943,000.

Other expenses for the year ended December 31, 2004 were $3,766,000, compared to $2,343,000 for the
year ended December 31, 2003. This increase was due primarily to an increase in professional service fees of
$426,000 (due primarily to the addition of Belvedere Trust and its lending and securitization activities), an

increase in fees relating to residential real estate loan acquisitions and securitizations (Belvedere Trust) of
$528,000, an increase in software and implementation costs of $194,000 (due primarily to the demands of
Sarbanes-Oxley regulations), an increase in consulting fees of $182,000 (due primarily to Sarbanes-Oxley
regulations) and a net increase in other costs of $93,000 (due primarily to Belvedere Trust).

Years Ended December 31, 2003 and 2002

For the year ended December 31, 2003, our net income was $50,195,000, or $1.52 per diluted share, based

on an average of 33,112,059 shares outstanding. For the year ended December 31, 2002, our net income was
$31,670,000, or $1.80 per diluted share, based on an average of 17,590,888 shares outstanding. The decrease in
our earnings per share in 2003 over 2002 was due to an increase in premium amortization expense. The increase
in premium amortization expense resulted from an increase in the constant prepayment rate (“CPR”) of our
mortgage-backed securities, resulting primarily from an extremely high volume of mortgage refinancings driven
by the record-low interest rates. These refinancings occurred mainly in the second quarter and their net effect was
realized through the increase in premium amortization expense in the third quarter.

The table below shows the approximate constant prepayment rate of our mortgage assets:

2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2002 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

35%
33%

40%
33%

46%
28%

32%
33%

First
Quarter

Second
Quarter

Third
Quarter

Fourth
Quarter

Net interest income for the year ended December 31, 2003 totaled $54,416,000, or 54.4% of total interest
income, compared to $37,279,000, or 55.8% of total interest income, for the year ended December 31, 2002. Net
interest income is comprised of the interest income earned on mortgage investments less interest expense from
borrowings. As a result of investing the proceeds of our common stock offerings, our assets and borrowing have
increased significantly from last year. This has resulted in a large increase in our income and interest expense in
2003 compared to 2002. Also, during the year ended December 31, 2003, we realized a net gain on the sale of
assets in the amount of $3,497,000, or 3.5% of total interest income, compared to $4,708,605, or 7.0% of total
interest income, during the year ended December 31, 2002.

For the year ended December 31, 2003, our operating expenses increased to $7,718,000, or 7.7% of total
interest income, from $4,701,227, excluding acquisition costs and fees paid to external management company, or
7.0% of total interest income, for the year ended December 31, 2002. This increase was due primarily to the
internalization of the management of our company and increased expenses associated with compensation paid
under our incentive compensation plan.

Financial Condition

At December 31, 2004, we held agency mortgage assets whose amortized cost was approximately $4.61

billion, consisting primarily of $4.38 billion of adjustable-rate mortgage-backed securities, $18 million of
floating rate CMOs and $206 million of fixed-rate mortgage-backed securities. This amount represents an
approximate 8.5% increase from the $4.25 billion held at December 31, 2003. Of the adjustable-rate agency
mortgage-backed securities owned by us, 33% were adjustable-rate pass-through certificates whose coupons reset
within one year. The remaining 67% consisted of hybrid adjustable-rate mortgage-backed securities whose
coupons will reset between one year and five years. Hybrid adjustable-rate mortgage-backed securities have an
initial interest rate that is fixed for a certain period, usually three to five years, and thereafter adjust annually for
the remainder of the term of the loan.

Agency Securities

The following table presents a schedule of agency mortgage-backed securities at fair value owned at

December 31, 2004 and December 31, 2003, classified by type of issuer (dollar amounts in thousands):

Agency

At December 31, 2004

At December 31, 2003

Fair
Value

Portfolio
Percentage

Fair
Value

Portfolio
Percentage

Fannie Mae (FNM) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Freddie Mac (FHLMC) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Ginnie Mae (GNMA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$3,301,406
1,157,910
129,225

72.0% $2,984,941
25.2% 1,059,517
201,395
2.8%

70.3%
25.0%
4.7%

Total agency mortgage-backed securities . . . . . . . . . . . . .

$4,588,541

100.0% $4,245,853

100.0%

The following table classifies our portfolio of agency mortgage-backed securities owned at December 31,

2004 and December 31, 2003, by type of interest rate index (dollar amounts in thousands):

Index

At December 31, 2004

At December 31, 2003

Fair
Value

Portfolio
Percentage

Fair
Value

Portfolio
Percentage

One-month LIBOR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Six-month LIBOR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
One-year LIBOR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Six-month Certificate of Deposit
. . . . . . . . . . . . . . . . . . . . . . .
Six-month Constant Maturity Treasury . . . . . . . . . . . . . . . . . .
One-year Constant Maturity Treasury . . . . . . . . . . . . . . . . . . .
Cost of Funds Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Fixed-Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

18,584
20,008
2,251,782
6,402
1,648
2,006,235
82,367
201,515

30,184
0.4% $
17,131
0.5%
49.1% 1,439,064
8,831
0.1%
1,874
0%
43.7% 2,241,179
105,854
1.8%
401,736
4.4%

0.7%
0.4%
33.9%
0.2%
0%
52.8%
2.5%
9.5%

Total agency mortgage-backed securities . . . . . . . . . . . . .

$4,588,541

100.0% $4,245,853

100.0%

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

Our total agency portfolio had a weighted average coupon of 4.28% at December 31, 2004. The average
coupon of the adjustable-rate securities was 4.13%, the hybrid average coupon was 4.30%, the CMO floaters
average coupon was 3.22% and the average coupon of the fixed-rate securities was 5.12%.

At December 31, 2004, the unamortized net premium paid for our mortgage-backed securities was $111

million.

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

As of December 31, 2004, the average amortized cost of our agency mortgage-related assets was 102.5%,

the average amortized cost of the adjustable-rate securities was 102.5% and the average amortized cost of the
fixed-rate securities was 102.9%. Relative to our agency MBS portfolio, as of December 31, 2004, the average
interest rate on outstanding repurchase agreements was 2.25% and the average days to maturity was 184 days.
After adjusting for interest rate swap transactions, the average interest rate on outstanding repurchase agreements
was 2.34% and the weighted average term to next rate adjustment was 304 days.

Residential Real Estate Loans (Belvedere Trust)

Residential real estate loans held for securitization and held in securitization trusts are reflected in the
financial statements at their amortized cost. At December 31, 2004, residential real estate loans consisted of the
following (in thousands):

Residential Real Estate Loans

Residential
Real Estate
Loans Pending
Securitization

Residential Real
Estate Loans,
Securitized

Total Residential
Real Estate
Loans

Principal balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Unamortized premium and expenses . . . . . . . . . . . . . . . . . . . . . .

$566,748
11,184

$2,015,175
35,227

$2,581,923
46,411

Carrying value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$577,932

$2,050,402

$2,628,334

As of December 31, 2004, residential real estate loans consisted of the following (in thousands)

Loan Description

First Lien Adjustable-Rate
Residential Real Estate
Loans . . . . . . . . . . . . . . . . .

Interest Rate

Maturity
Date

Principal
Balance

Delinquent
Balance
(30 Days)

Delinquent
Balance
(60+ Days)

Interest Rate
Type

Moving
Treasury

Average ARM 1.000% – 6.000% 2034 – 2035 $ 492,003 $ — $ —

First Lien Adjustable-Rate
Residential Real Estate
Loans . . . . . . . . . . . . . . . . . 1-Month ARM 1.000% – 5.750%

2034

153,546

—

First Lien Adjustable-Rate
Residential Real Estate
Loans . . . . . . . . . . . . . . . . . 6-Month ARM 2.250% – 6.750% 2033 – 2035

549,270

1,939

—

First Lien Adjustable-Rate
Residential Real Estate
Loans . . . . . . . . . . . . . . . . .

1-Year ARM 3.625% – 7.125% 2033 – 2034

8,600

—

First Lien Adjustable-Rate
Residential Real Estate
Loans . . . . . . . . . . . . . . . . . 3-Year Hybrid 2.875% – 7.000% 2033 – 2035

First Lien Adjustable-Rate
Residential Real Estate
Loans . . . . . . . . . . . . . . . . . 5-Year Hybrid 3.375% – 7.125% 2033 – 2035

First Lien Adjustable-Rate
Residential Real Estate
Loans . . . . . . . . . . . . . . . . . 7-Year Hybrid 3.750% – 6.625% 2033 – 2035

First Lien Adjustable-Rate
Residential Real Estate
Loans . . . . . . . . . . . . . . . . . 10-Year Hybrid 4.500% – 6.750% 2034 – 2035

359,181

3,838

110

777,493

5,406

350

217,700

1,219

754

24,130

—

$2,581,923 $12,402

$1,214

As of December 31, 2004, the residential real estate loans consisted of the following (in thousands):

Range of Carrying Amounts of Loans

Number of
Loans

Principal
Balance

$0–$99 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$100–$149 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$150–$199 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$200–$249 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$250–$299 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$300–$349 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$350–$399 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$400–$449 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$450–$499 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

261

779

760

719

585

634

804

611

474

$500–$749 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1,030

$750–$999 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$1,000 & greater . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

275

140

16,976

97,545

131,914

160,615

159,731

206,815

301,503

258,586

224,893

607,384

243,157

172,804

7,072

$2,581,923

The weighted average coupon on whole loans which we have securitized was 4.30% at December 31, 2004.

Geographic Concentration

December 31,
2004

Southern California . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Northern California . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Florida . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Virginia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Illinois . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Colorado . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Michigan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Nevada . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Other states (none greater than 2%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

32%
21%
6%
4%
3%
3%
3%
3%
25%

Total: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

100%

Our residential real estate loan portfolio of $2.63 billion as of December 31, 2004 includes $578 million of
loans pending securitization and $2.05 billion in loans which have been securitized. The securitized residential
real estate loans serve as collateral for $1.49 billion of mortgage-backed securities issued and $545 million of
repurchase agreement financings. Belvedere Trust structures securitization transactions primarily through special
purpose entities (such as real estate mortgage investment conduit, or REMIC, trusts). The principal business
activity involves issuing various series of mortgage-backed securities (in the form of pass-through certificates or
bonds collateralized by residential real estate loans). The collateral specific to each mortgage-backed securities
series is the sole source of repayment of the debt and, therefore, our exposure to loss is limited to our net
investment in the collateral. Although the $2.05 billion of residential real estate loans which have been
securitized are consolidated on our balance sheets, the special purpose entities that hold such loans, including
BellaVista Funding Corporation, are legally separate from us and Belvedere Trust. Consequently, the assets of
these special purpose entities (including the securitized mortgage loans) are not available to our creditors or to
creditors of Belvedere Trust, and such mortgage loans are not assets of Anworth or of Belvedere Trust. Only our
interest in the securities issued by the special purpose entities are legal assets of Anworth and Belvedere Trust.

At December 31, 2004, Belvedere Trust owned approximately $578 million in loans held for securitization.
This figure includes the face amount of the mortgages as well as accrued interest and premium or discount. The
loans consist of adjustable-rate single-family residential mortgages and hybrid single-family mortgages with
initial fixed-rate periods of three to ten years.

Hedging

We periodically enter into derivative transactions, in the form of forward purchase commitments and
interest rate swaps, which are intended to hedge our exposure to rising rates on funds borrowed to finance our
investments in securities. We designate these transactions as cash flow hedges. We also enter into derivative
transactions, in the form of forward purchase commitments, which are not designated as hedges. To the extent
that we enter into hedging transactions to reduce our interest rate risk on indebtedness incurred to acquire or
carry real estate assets, any income or gain from the disposition of hedging transactions should be qualifying
income for purposes of the 95% gross income test, but not the 75% gross income test.

As part of our asset/liability management policy, we may enter into hedging agreements such as interest rate

caps, floors or swaps. These agreements would be entered into to try to reduce interest rate risk and would be
designed to provide us with income and capital appreciation in the event of certain changes in interest rates. We
review the need for hedging agreements on a regular basis consistent with our capital investment policy. At
December 31, 2004, we were a counter-party to swap agreements, which are derivative instruments as defined by
FASB 133 and FASB 138, with an aggregate notional amount of $400 million and an average maturity of 3.6
years. We utilize swap agreements to manage interest rate risk and do not anticipate entering into derivative
transactions for speculative or trading purposes. In accordance with the swap agreements, we pay a fixed rate of
interest during the term of the swap agreements and receive a payment that varies with the three-month LIBOR
rate. At December 31, 2004, there were unrealized gains of approximately $4.1 million on our swap agreements.

During the year ended December 31, 2004, we also entered into Eurodollar transactions in order to mitigate
the impact of rising interest rates on planned securitization funding. There is typically a time difference between
the date we enter into an agreement to purchase whole loans and the date on which we fix the interest rates paid
for securitization financing. We are exposed to interest rate fluctuations during this period. In order to mitigate
this risk, we hedge our position using Eurodollar futures. Once the financing rates on the securitization are fixed,
we remove the hedge positions. In accordance with FASB 133, we recognize the change in value of the projected
cash flows on loans that we have purchased and loans that we have committed to purchase as well as the change
in value of the hedge instruments. The difference between these changes in value (the hedging ineffectiveness) is
included in income during the current period. For the year ended December 31, 2004, there were recognized
gains, net of recognized losses, of $340,000.

Liquidity and Capital Resources

Our primary source of funds consists of repurchase agreements, relative to our agency MBS portfolio, which

totaled $4.17 billion at December 31, 2004 and Belvedere Trust’s repurchase agreements, which totaled
$545 million at December 31, 2004. Belvedere Trust also had $556 million in whole loan financing facilities at
December 31, 2004. Our other significant source of funds for the year ended December 31, 2004 consisted of
payments of principal from our agency mortgage securities portfolio in the amount of $1.75 billion and
$141 million from our residential real estate loans.

Relative to our agency MBS portfolio, as of December 31, 2004, all of our repurchase agreements were

fixed-rate term repurchase agreements with original maturities ranging from one to twenty-four months.
Belvedere Trust enters into its own repurchase agreements. As of December 31, 2004, other than three
repurchase agreements that reprice monthly subject to a cap, all of Belvedere Trust’s repurchase agreements were
fixed-rate term repurchase agreements with original maturities ranging from one to thirty-six months. On
December 31, 2004, we had borrowing arrangements with 19 different financial institutions and had borrowed

funds under repurchase agreements with 13 of these firms. As the repurchase agreements mature, we enter into
new repurchase agreements to take their place. Because we borrow money based on the fair value of our
mortgage-backed securities and because increases in short-term interest rates can negatively impact the valuation
of mortgage-backed securities, our borrowing ability could be reduced and lenders may initiate margin calls in
the event short-term interest rates increase or the value of our mortgage-backed securities declines for other
reasons. We had adequate cash flow, liquid assets and unpledged collateral with which to meet our margin
requirements during the year ended December 31, 2004.

We acquire residential mortgage loans from third party originators, including banks and other mortgage
lenders, through our Belvedere Trust subsidiary. Belvedere Trust structures securitization transactions primarily
through special purpose entities (such as real estate mortgage investment conduit, or REMIC, trusts). The
principal business activity involves issuing various series of mortgage-backed securities (in the form of pass-
through certificates or bonds collateralized by residential real estate loans). The collateral specific to each
mortgage-backed securities series is the sole source of repayment of the debt and, therefore, our exposure to loss
is limited to our net investment in the collateral. During the three months ended December 31, 2004, Belvedere
Trust transferred approximately $1.1 billion of residential mortgage loans in two separate transactions to
securitization trusts, which were non-qualified SPEs, pursuant to pooling and third party servicing agreements.
During the three months ended September 30, 2004, we transferred approximately $391 million of residential
mortgage loans to a securitization trust, which was a non-qualified SPE, pursuant to a pooling and third party
servicing agreement dated as of July 1, 2004. During the three months ended June 30, 2004, we transferred
approximately $345 million of residential mortgage loans (of which $147 million were purchased during the
second quarter of 2004) to a securitization trust, which was a non-qualified SPE, pursuant to a pooling and third
party servicing agreement dated as of April 1, 2004, and we acquired approximately $314 million of residential
mortgage loans which were transferred to a securitization trust pursuant to a pooling and third party servicing
agreement dated as of May 1, 2004. The servicing of the mortgage loans is performed by third parties under
servicing arrangements that resulted in no servicing asset or liability.

Five of the six securitization transactions in the year ended December 31, 2004 were accounted for as
financings. The residential real estate loans remain as assets on our balance sheet subsequent to securitization,
and the financing resulting from these securitizations is shown on our consolidated balance sheets as “mortgage-
backed securities issued.”

During the three months ended March 31, 2004, we transferred approximately $253 million of residential

mortgage loans to a securitization trust, which was a qualified SPE, pursuant to a pooling and third party
servicing agreement dated as of February 1, 2004. The transaction was accounted for as a sale. The securities are
carried at amortized cost, adjusted for fair market valuation based on quoted market prices. As these securities
include first loss security, we bear the credit risk associated with these mortgages. The principal balance
outstanding, at December 31, 2004, of all the securities from this transaction was $179 million; the amount
derecognized was $134 million and the amount recognized as our retained securities was $45 million. The
delinquent amount of all the principal balances from this transaction was $3 million and there have been no credit
losses to date.

In the future, we expect that our primary sources of funds will continue to consist of borrowed funds under

repurchase agreement transactions with one to twenty-four month maturities and of monthly payments of
principal and interest on our mortgage-backed securities portfolio. Our liquid assets generally consist of
unpledged mortgage-backed securities, cash and cash equivalents.

On April 21, 2004, we entered into a sales agreement with Cantor Fitzgerald & Co. (“Cantor”) to sell up to
6.0 million shares of common stock from time to time through a controlled equity offering program under which
Cantor will act as sales agent. Sales of the shares will be made on the New York Stock Exchange by means of
ordinary brokers’ transactions at market prices and through privately negotiated transactions. We intend to make
such sales when we believe the issuance of stock would be accretive to our stockholders. Through December 31,

2004, we sold 292,500 shares under the controlled equity offering program which provided net proceeds to us of
approximately $3.2 million. The sales agent received an aggregate of approximately $99,000, which represents a
commission of 3% on the gross sales price per share under the sales agreement through December 31, 2004.

During the year ended December 31, 2004, we had raised approximately $41.6 million in capital under our
Dividend Reinvestment and Stock Purchase Plan and various officers and employees exercised stock options to
purchase approximately 68,000 shares, resulting in proceeds to us of approximately $0.6 million.

At December 31, 2004, our authorized capital included 20 million shares of $0.01 par value preferred stock.
During the quarter ended December 31, 2004, we issued 1,101,300 shares of Series A preferred stock, par value
$0.01 per share, liquidation preference $25.00 per share, resulting in net proceeds to us of approximately $26.4
million.

As of December 31, 2004, Belvedere Trust has entered into commitments to purchase mortgage loans in the

amount of $351 million and whole loan financing facilities which provide for up to $850 million in financing
secured by single-family mortgage loans. At December 31, 2004, Belvedere Trust has borrowed $556 million
under the facilities, secured by mortgage loans held for securitization with a face value of $567 million.

Off-Balance Sheet and Contractual Arrangements

The following table represents the Company’s contractual obligations as of December 31, 2004 (in

thousands):

Payments Due By Period

Total

Less Than
1 Year

1-3 Years

3-5 Years

More Than
5 Years

Repurchase agreements

(Anworth Mortgage(1))

. . . . . . . . . . . . . . . . .
Repurchase agreements (Belvedere Trust(1))
. .
Whole loan financing facilities . . . . . . . . . . . . . .
Mortgage-backed securities issued(2)
. . . . . . . .
Purchase commitments . . . . . . . . . . . . . . . . . . . .

$4,172,930
544,506
556,233
1,494,851
350,513

$3,705,930
275,631
556,233
373,523
350,513

$ 467,000
268,875

—
490,249
—

$ — $ —
—
—
355,314
—

—
—
275,765
—

Total(3) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$7,119,033

$5,261,830

$1,226,124

$275,765

$355,314

(1) These represent amounts due by maturity.
(2) Principal is paid on the mortgage-backed securities issued following receipt of principal payments on the
loans. For the table above, the principal payments have been estimated based on prepayment assumptions.
The actual principal paid in each year will be dependent upon the principal received on the underlying loans.

(3) This does not include annual compensation agreements, leases and incentive compensation agreements

which are more fully described in Note 9.

Stockholders’ Equity

We use available-for-sale treatment for our agency mortgage-backed securities which are carried on our

balance sheet at fair value rather than historical cost. Real estate loans are carried at historical cost. Based upon
these treatments, our total equity base at December 31, 2004 was $507 million. Common stockholders’ equity
was approximately $480 million, or $10.31 book value per share.

Under our available-for-sale accounting treatment, unrealized fluctuations in fair values of assets do not

impact GAAP income or taxable income but rather are reflected on the balance sheet by changing the carrying
value of the asset and reflecting the change in stockholders’ equity under Accumulated Other Comprehensive
Income, Unrealized Gain (Loss) on Available-for-Sale Securities.

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 on all of our assets. As a result,
comparisons with some companies that use historical cost accounting for all of their balance sheet may not be
meaningful.

Unrealized changes in the fair value of mortgage-backed securities have one significant and direct effect on
our potential earnings and dividends: positive mark-to-market changes will increase our equity base and allow us
to increase our borrowing capacity while negative changes will tend to reduce borrowing capacity under our
capital investment policy. A very large negative change in the net market value of our mortgage-backed
securities might reduce our liquidity, requiring us to sell assets with the likely result of realized losses upon sale.
Accumulative Other Comprehensive Income, Unrealized Loss on Available-for-Sale Agency Securities was
$45.5 million or 1% of the amortized cost of agency mortgage-backed securities at December 31, 2004. This,
along with Accumulative Other Comprehensive Gain, Derivatives, of $4.1 million, and Accumulative Other
Comprehensive Loss, Other MBS, of $1.2 million, constitute the total Accumulative Other Comprehensive Loss
of $42.6 million.

Critical Accounting Policies

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

The preparation of financial statements in accordance with generally accepted accounting principles requires

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

Our accounting policies are described in Note 1 to our financial statements. Management believes the more

significant of these to be as follows:

Revenue Recognition

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

Interest income on our mortgage-backed securities is accrued based on the actual coupon rate and the
outstanding principal amount of the underlying mortgages. Premiums and discounts are amortized or accreted
into interest income over the expected lives of the securities using the effective interest yield method adjusted for
the effects of estimated prepayments based on the Statement of Financial Accounting Standards, or SFAS, No.
91, “Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial
Direct Costs of Leases,” an amendment of FASB Statements No. 13, 60, and 65 and a rescission of FASB
Statement No. 17. Our policy for estimating prepayments speeds for calculating the effective yield is to evaluate
historical performance, street consensus prepayment speeds and current market conditions. If our estimate of
prepayments is incorrect, we may be required to make an adjustment to the amortization or accretion of
premiums and discounts that would have an impact on future income.

Allowance for Loan Losses

We establish and maintain an allowance for estimated loan losses inherent in our residential real estate loan
portfolio. The loan loss reserves are based upon our assessment of various factors affecting the credit quality of
our assets including, but not limited to, the characteristics of the loan portfolio, review of loan level data,
borrowers’ credit scores, delinquency and collateral value. The reserves are reviewed on a regular basis and
adjusted as deemed necessary. The allowance for loan losses on our real estate loans is established by taking loan
loss provisions through our consolidated statements of income.

Valuation of Investment Securities

We carry our investment securities on the balance sheet at fair value. The fair values of our mortgage-

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

In March 2004, the Emerging Issues Task Force (EITF) of the FASB reached a consensus on Issue 03-1,
“The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments”. This EITF
applies to all debt and equity securities currently accounted for under FASB 115, “Accounting for Certain
Investments in Debt and Equity Securities”. EITF 03-1 requires an evaluation of whether impairment is other
than temporary. An impairment loss is equal to the difference between the investment’s cost and fair value. An
impairment is considered other than temporary if the investor does not have the ability and intent to hold for a
reasonable period of time sufficient for recovery of fair value and if it is probable that the investor will be unable
to collect all contractual amounts due or if the impairment is considered other than a minor impairment. A minor
impairment is considered 5% or less of value. For ordinary debt securities with no credit problems where the
decrease in fair value is caused solely by rising interest rates, an impairment is deemed other than temporary
unless the investor has the ability and intent to hold for a reasonable period of time sufficient for recovery of fair
value or if it is considered a minor impairment. The Company has reviewed its securities portfolio and does not
consider those securities that have been in a continuous loss position for 12 months or more to be other than
temporarily impaired due to the fact that they are government-sponsored agency securities with limited credit
risk and the Company has the ability and intent to hold these securities until a forecasted recovery, which may
mean until maturity. The FASB suspended the effective date of the consensus, other than disclosure
requirements.

Variable Interest Entities

In January 2003, the Financial Accounting Standards Board, or FASB, issued FASB Interpretation No. 46,

Belvedere Trust structures securitization transactions primarily through non-qualified special purpose
entities (such as real estate mortgage investment conduit, or REMIC, trusts). The principal business activity
involves issuing various series of mortgage-backed securities (in the form of pass-through certificates or bonds

collateralized by residential real estate loans). The collateral specific to each series of mortgage-backed securities
is the sole source of repayment of the debt and, therefore, our exposure to loss is limited to our net investment in
the collateral. Under FIN 46, these interests in non-qualified special purpose entities are deemed to be VIEs and
we are considered the primary beneficiary. In addition, we consolidate our interest in loans financed through
warehouse agreements where we are acquiring assets prior to securitization. We disclose our interests in VIEs
under FIN 46 in the Investments in Residential Real Estate Loans footnote.

Income Taxes

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

BT Finance, our indirect wholly-owned subsidiary, is a taxable REIT subsidiary and may be liable for

corporate income tax expenses.

Subsequent Events

On January 19, 2005, we entered into an Amended and Restated Sales Agreement with Cantor to sell up to

2.0 million shares of our Series A Preferred Stock, and up to 5.7 million shares of our Common Stock, from time
to time through a controlled equity offering program under which Cantor acts as sales agent. The agreement
amended and restated the Sales Agreement that we entered into on April 21, 2004 with Cantor. Sales of the
shares of our Series A Preferred Stock and Common Stock are made on the New York Stock Exchange by means
of ordinary brokers’ transactions at market prices and through privately negotiated transactions. From
January 19, 2005 through March 14, 2005, we sold 509,200 shares of Series A Preferred Stock under the
controlled equity offering program which provided net proceeds to us of approximately $12.6 million. The sales
agent received an aggregate of approximately $337,000, which represents an average commission of
approximately 2.6% on the gross sales price per share.

On January 28, 2005, BellaVista Funding Corporation completed a securitization of mortgage-backed
securities backed by adjustable-rate and hybrid mortgage loans. The total amount of the securities underwritten
was approximately $898 million. These mortgage loans were purchased by BellaVista Funding Corporation from
Belvedere Trust Finance Corporation, another of our wholly-owned indirect subsidiaries. Belvedere Trust has
previously completed six other securitizations of mortgage loans and, since its formation, has securitized $3.3
billion of mortgage loans.

RISK FACTORS

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

General Risks Related to Our Business

Our leveraging strategy increases the risks of our operations.

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

•

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

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

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

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

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

Lloyd McAdams, Joseph E. McAdams, Thad M. Brown, Bistra Pashamova and other of our officers and

employees are officers and employees of Pacific Income Advisers, Inc., or PIA, where they devote a portion of
their time. These officers and employees are under no contractual obligations mandating minimum amounts of
time to be devoted to our company. In addition, a trust controlled by Lloyd McAdams and Heather U. Baines is
the principal stockholder of PIA.

These officers and employees are involved in investing both our assets and approximately $4.6 billion in

mortgage-backed securities and other fixed income assets for institutional clients and individual investors
through PIA. These multiple responsibilities and ownerships may create conflicts of interest if these officers and

employees of our company are presented with opportunities that may benefit both us and the clients of PIA.
These officers allocate investments among our portfolio and the clients of PIA by determining the entity or
account for which the investment is most suitable. In making this determination, these officers consider the
investment strategy and guidelines of each entity or account with respect to acquisition of assets, leverage,
liquidity and other factors that our officers determine appropriate. These officers, however, have no obligation to
make any specific investment opportunities available to us and the above mentioned conflicts of interest may
result in decisions or allocations of securities that are not in our best interests.

Several of our officers and employees are also directors, officers and managers of BT Management
Company, L.L.C., the company that manages the day-to-day operations of Belvedere Trust, our mortgage loan
subsidiary, and Lloyd McAdams is also an owner and officer of Syndicated Capital, a registered broker-dealer.
Our officers’ service to PIA, BT Management Company, L.L.C. and Syndicated Capital allow them to spend
only part of their time and effort managing our company as they are required to devote a portion of their time and
effort to the management of other companies and this may adversely affect our overall management and
operating results.

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

Currently, all of our borrowings are collateralized borrowings in the form of repurchase and warehouse

agreements. If the interest rates on these agreements increase, that would adversely affect our profitability.

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

•

the movement of interest rates;

the availability of financing in the market; and

the value and liquidity of our mortgage-backed securities.

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

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

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

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

If we cannot renew or replace maturing borrowings, we may have to sell our mortgage-related assets under

adverse market conditions and may incur permanent capital losses as a result. Any number of these factors in
combination may cause difficulties for us, including a possible liquidation of a major portion of our portfolio at
disadvantageous prices with consequent losses, which may render us insolvent.

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

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

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

Our borrowings under repurchase agreements may qualify for special treatment under the bankruptcy code,

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

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

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

Our hedging strategies may not be successful in mitigating our risks associated with interest rates.

We engage in hedging activity. As such, we use various derivative financial instruments to provide a level

of protection against interest rate risks, but no hedging strategy can protect us completely. When interest rates
change, we expect to record a gain or loss on derivatives, which would be offset by an inverse change in the
value of loans or residual interests. Additionally, from time to time, we may enter into hedging transactions in
connection with our holdings of mortgage-backed securities and government securities with respect to one or
more of our assets or liabilities. Our hedging activities may include entering into interest rate swaps, caps and
floors, options to purchase these items, and futures and forward contracts. Currently, we intend to primarily use
interest rate swap agreements to manage the interest rate risk of our portfolio of mortgage-backed securities and
Eurodollar futures contracts to manage the interest rate risk associated with holding loans in our warehouse
facility before securitization; however, our actual hedging decisions will be determined in light of the facts and
circumstances existing at the time and may differ from our currently anticipated hedging strategy. We cannot
assure you that our use of derivatives will offset the risks related to changes in interest rates. It is likely that there
will be periods in the future during which we will incur losses after accounting for our derivative financial
instruments. The derivative financial instruments we select may not have the effect of reducing our interest rate
risk. In addition, the nature and timing of hedging transactions may influence the effectiveness of these
strategies. Poorly designed strategies or improperly executed transactions could actually increase our risk and
losses. In addition, hedging strategies involve transaction and other costs. We cannot assure you that our hedging
strategy and the derivatives that we use will adequately offset the risk of interest rate volatility or that our
hedging transactions will not result in losses.

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

Our net income largely depends on our ability to acquire mortgage-related assets at favorable spreads over

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

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

Our board of directors can modify or waive our current operating policies and our strategies without prior

notice and without stockholder approval. We cannot predict the effect any changes to our current operating
policies and strategies may have on our business, operating results and stock price, however, the effects may be
adverse.

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

We depend on the diligence, experience and skill of our officers and other employees for the selection,
structuring and monitoring of our mortgage-related assets and associated borrowings. Our key officers include
Lloyd McAdams, President, Chairman and Chief Executive Officer, Joseph E. McAdams, Chief Investment
Officer, Executive Vice President and Director, Thad M. Brown, Chief Financial Officer, Charles J. Siegel,
Senior Vice President, Evangelos Karagiannis, Vice President and Bistra Pashamova, Vice President. Belvedere
Trust’s key officers are Claus Lund and Russell Thompson. Our dependence on our key personnel is heightened
by the fact that we have a relatively small number of employees, and the loss of any key person could harm our
entire business, financial condition, cash flow and results of operations. In particular, the loss of the services of
Lloyd McAdams or Joseph E. McAdams could seriously harm our business.

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

In addition to their base salaries, management and key employees are eligible to earn incentive

compensation for each fiscal year pursuant to our incentive compensation plan. Under the plan, the aggregate
amount of compensation that may be earned by all employees equals a percentage of taxable net income, before
incentive compensation, in excess of the amount that would produce an annualized return on average net worth
equal to the ten-year US Treasury Rate plus 1%. In any fiscal quarter in which our taxable net income is an
amount less than the amount necessary to earn this threshold return, we calculate negative incentive
compensation for that fiscal quarter which will be carried forward and will offset future incentive compensation
earned under the plan, but only with respect to those participants who were participants during the fiscal
quarter(s) in which negative incentive compensation was generated. Although negative incentive compensation is
used to offset future incentive compensation, as our management evaluates different mortgage-backed securities
for our investment, there is a risk that management will cause us to assume more risk than is prudent.

Risk Related Primarily to Anworth’s Business

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

We fund most of our acquisitions of adjustable-rate mortgage-backed securities with borrowings that have

interest rates based on indices and repricing terms similar to, but of shorter maturities than, the interest rate
indices and repricing terms of our mortgage-backed securities. Accordingly, if short-term interest rates increase,
this may adversely affect our profitability.

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

The interest rates on our borrowings generally adjust more frequently than the interest rates on our
adjustable-rate mortgage-backed securities. For example, at December 31, 2004, our agency adjustable-rate
mortgage-backed securities had a weighted average term to next rate adjustment of approximately 23 months,
while our borrowings had a weighted average term to next rate adjustment of 184 days. After adjusting for
interest rate swap transactions, the weighted average term to next rate adjustment was 304 days. Accordingly, in
a period of rising interest rates, we could experience a decrease in net income or a net loss because the interest
rates on our borrowings adjust faster than the interest rates on our adjustable-rate mortgage-backed securities.

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

Pools of mortgage loans underlie the mortgage-backed securities that we acquire. We generally receive

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

• We usually purchase mortgage-backed securities that have a higher interest rate than the market

interest rate at the time. In exchange for this higher interest rate, we pay a premium over the par value
to acquire the security. In accordance with accounting rules, we amortize this premium over the term of
the mortgage-backed security. If the mortgage-backed security is prepaid in whole or in part prior to its
maturity date, however, we expense the premium that was prepaid at the time of the prepayment. At
December 31, 2004, substantially all of our mortgage-backed securities had been acquired at a
premium.

• We anticipate that a substantial portion of our adjustable-rate mortgage-backed securities may bear

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

•

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

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

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

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

We generally fund our acquisition of fixed-rate mortgage-backed securities with short-term borrowings.
During periods of rising interest rates, our costs associated with borrowings used to fund acquisition of fixed-rate

assets are subject to increases while the income we earn from these assets remains substantially fixed. This
reduces or could eliminate the net interest spread between the fixed-rate mortgage-backed securities that we
purchase and our borrowings used to purchase them, which could lower our net interest income or cause us to
suffer a loss. At December 31, 2004, 4% of our mortgage-backed securities were fixed-rate securities.

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

Our adjustable-rate mortgage-backed securities are subject to periodic and lifetime interest rate caps.

Periodic interest rate caps limit the amount an interest rate can increase during any given period. Lifetime interest
rate caps limit the amount an interest rate can increase through maturity of a mortgage-backed security. Our
borrowings are not subject to similar restrictions. Accordingly, in a period of rapidly increasing interest rates, the
interest rates paid on our borrowings could increase without limitation while interest rate caps would limit the
interest rates on our adjustable-rate mortgage-backed securities. This problem is magnified for our adjustable-rate
mortgage-backed securities that are not fully indexed. Further, some adjustable-rate mortgage-backed securities
may be subject to periodic payment caps that result in a portion of the interest being deferred and added to the
principal outstanding. As a result, we could receive less cash income on adjustable-rate mortgage-backed
securities than we need to pay interest on our related borrowings. These factors could lower our net interest
income or cause us to suffer a loss during periods of rising interest rates. At December 31, 2004, approximately
96% of our agency mortgage-backed securities were adjustable-rate securities.

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

We may acquire leveraged mortgage derivative securities that may expose us to a high level of interest rate

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

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

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

Risk Related Primarily to Belvedere Trust’s Business

We have only limited experience in the business of acquiring and securitizing whole mortgage loans and we
may not be successful.

Belvedere Trust, which was formed as our subsidiary in 2003, is engaged in the business of acquiring and
securitizing mortgage loans. The acquisition of whole loans and the securitization process are inherently complex
and involve risks related to the types of mortgages we seek to acquire, interest rate changes, funding sources,
delinquency rates, borrower bankruptcies and other factors that we may not be able to manage. Incorrect
management of these risks may take years to become apparent. Our failure to manage these and other risks could
have a material adverse effect on our business and on the results of our operations.

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

While Belvedere Trust securitizes the loans that it acquires into high quality assets in order to achieve better

financing rates and to improve its access to financing, it bears the risk of loss on any loans that its acquires or
originates and which it subsequently securitizes. Belvedere Trust acquires loans that are not credit enhanced and
that do not have the backing of Fannie Mae or Freddie Mac. Accordingly, it is subject to risks of borrower
default, bankruptcy and special hazard losses (such as those occurring from earthquakes) with respect to those
loans to the extent that there is any deficiency between the value of the mortgage collateral and insurance and the
principal amount of the loan. In the event of a default on any such loans that it holds, Belvedere Trust would bear
the loss of principal between the realized value of the mortgaged property and the outstanding indebtedness, as
well as foreclosure costs and the loss of interest. We have not established any limits upon the geographic
concentration or the credit quality of suppliers of the mortgage-related assets that we acquire.

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

Belvedere Trust requires substantial cash to fund its loan acquisitions, to pay its loan acquisition expenses

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

We have invested $96 million in Belvedere Trust to capitalize its mortgage operations. If Belvedere Trust
fully invests all of the proceeds of our investments in it prior to the point at which Belvedere Trust can access
external sources of capital, if it ever can, then Belvedere Trust will need to either restructure the securities
supporting its portfolio, require additional capital from us or, if it is unable to sell additional securities on
reasonable terms or at all, it will need to either reduce its acquisition business or sell a higher portion of its loans.
In the event that Belvedere Trust’s liquidity needs exceed its access to liquidity, it may need to sell assets at an
inopportune time, thus reducing its earnings. Adverse cash flow could threaten Belvedere Trust’s ability to
maintain its solvency or to satisfy the income and asset tests necessary to elect and maintain REIT status.

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

If Belvedere Trust utilizes over-collateralization as a credit enhancement to its securitizations, it expects that

such over-collateralization will restrict its cash flow if loan delinquencies exceed certain levels. The terms of its
securitizations generally provide that, if certain delinquencies and/or losses exceed the specified levels based on
rating agencies’ (or the financial guaranty insurer’s, if applicable) analysis of the characteristics of the loans
pledged to collateralize the securities, the required level of over-collateralization may be increased or may be
prevented from decreasing as would otherwise be permitted if losses and/or delinquencies did not exceed those
levels. Other tests (based on delinquency levels or other criteria) may restrict Belvedere Trust’s ability to receive
net interest income from a securitization transaction. We cannot assure you that the performance tests will be
satisfied. Failure to satisfy performance tests may materially and adversely affect the availability of net excess
income to Belvedere Trust.

Representations and warranties made by Belvedere Trust in loan sales and securitizations may subject it to
liability.

In connection with securitizations, Belvedere Trust makes representations and warranties regarding the
mortgage loans transferred into securitization trusts. The trustee in the securitizations has recourse to Belvedere
Trust with respect to the breach of the standard representations and warranties regarding the loans made at the
time such mortgages are transferred. While Belvedere Trust generally has recourse to its loan originators for any
such breaches, there can be no assurance of the originators’ abilities to honor their respective obligations.
Belvedere Trust attempts to generally limit the potential remedies of the trustee to the potential remedies it
receives from the originators from whom it acquired the mortgages. However, in some cases, the remedies
available to the trustee may be broader than those available to Belvedere Trust against the originators of the
mortgages and should the trustee enforce its remedies against Belvedere Trust, it may not always be able to
enforce whatever remedies it has against its originators. Furthermore, if Belvedere Trust discovers, prior to the
securitization of a loan, that there is any fraud or misrepresentation with respect to the mortgage and the
originator fails to repurchase the mortgage, then Belvedere Trust may not be able to sell the mortgage or may
have to sell the mortgage at a discount.

Increased levels of early prepayments of mortgages may accelerate our expenses and decrease Belvedere
Trust’s net income.

Mortgage prepayments generally increase on Belvedere Trust’s ARMs when fixed mortgage interest rates
fall below the then-current interest rates on outstanding ARMs. Prepayments on mortgages are also affected by
the terms and credit grades of the mortgages, conditions in the housing and financial markets and general
economic conditions. If Belvedere Trust acquires mortgages at a premium and they are subsequently repaid, it
must expense the unamortized premium at the time of the prepayment. Also, if prepayments on mortgages
increase when interest rates are declining, Belvedere Trust’s net interest income may decrease if it cannot
reinvest the prepayments in mortgage assets bearing comparable rates.

Belvedere Trust’s business may be significantly harmed by a slowdown in the economy of California.

At December 31, 2004, approximately 53% of the residential real estate loans that Belvedere Trust owns or

credit enhances are secured by property in California. An overall decline in the economy or the residential real
estate market, or the occurrence of a natural disaster that is not covered by standard homeowners’ insurance
policies, such as an earthquake, could decrease the value of mortgaged properties in California. This, in turn,
would increase the risk of delinquency, default or foreclosure on real estate loans in Belvedere Trust’s residential
loan portfolios. This could adversely affect its credit loss experience and other aspects of its business, including
its ability to securitize real estate loans.

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

The success of Belvedere Trust’s mortgage loan business will depend to a great degree upon its ability to
ensure that its loans held for securitization are serviced effectively. In general, it is the intention of Belvedere
Trust to acquire loans “servicing retained,” where the loans will be serviced by the originating or selling
institution. Belvedere Trust has no experience servicing a portfolio of loans. In those instances where Belvedere
Trust is required to purchase the servicing of a loan portfolio in order to acquire a portfolio with desirable
attributes, Belvedere Trust will be required to sell the servicing rights, implement a servicing function or transfer
the servicing of the loans to a third party with whom it has established a sub-servicing relationship. We cannot
assure that Belvedere Trust will be able to service the loans or effectively supervise a sub-servicing relationship
according to industry standards. Failure to service the loans properly will harm Belvedere Trust’s business and
operating results. Prior to either building the servicing capabilities that Belvedere Trust may require or acquiring
an existing servicing operation that has such capabilities, if ever, Belvedere Trust has contracted with an

experienced servicer of non-conforming loans to “sub-service” its loans. The fees paid to such subservicer will
reduce to a certain extent the revenue Belvedere Trust is able to retain from its loans, and its net interest income
will be reduced and at risk, depending on the effectiveness of the servicing company.

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

If Belvedere Trust acquires the servicing rights to mortgage loans and subsequently retains the servicing

right separately from the loans, the allocated cost of the servicing rights will be reflected on its financial
statements. To determine the fair value of these servicing rights, Belvedere Trust will use assumptions to
estimate future net servicing income including projected discount rates, mortgage loan prepayments and credit
losses. If actual prepayments or defaults with respect to loans serviced occur more quickly than Belvedere Trust
originally assumed, Belvedere Trust would have to reduce the carrying value of its mortgage servicing rights.
There is no guarantee that Belvedere Trust’s assumptions will prove correct.

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

Belvedere Trust is externally managed pursuant to a management agreement between Belvedere Trust and

BT Management Company, L.L.C., or BT Management. Although we own 50% of BT Management, 50% is also
owned by the executive officers of Belvedere Trust. Our ability to generate profits from our ownership of
Belvedere Trust, if any, could be greatly diminished due to the fact that we will be required to pay a base
management fee to BT Management and we may also be required to pay an incentive fee. An externally managed
structure may not optimize our interest in Belvedere Trust and, if we are unable to properly manage fixed costs at
Belvedere Trust could, when combined with the base management fee, result in losses at Belvedere Trust.

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

Mr. McAdams, our Chairman and Chief Executive Officer, has a direct ownership interest in

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

Risks Related to REIT Compliance and Other Matters

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

We believe that since our initial public offering in 1998 we have operated so as to qualify as a REIT under

the Internal Revenue Code of 1986, as amended, or the Code, and we intend to continue to meet the requirements
for taxation as a REIT. Nevertheless, we may not remain qualified as a REIT in the future. Qualification as a
REIT involves the application of highly technical and complex Code provisions for which only a limited number
of judicial or administrative interpretations exist. Even a technical or inadvertent mistake could require us to pay
a penalty or jeopardize our REIT status. Furthermore, Congress or the IRS might change tax laws or regulations
and the courts might issue new rulings, in each case potentially having retroactive effects that could make it more
difficult or impossible for us to qualify as a REIT. If we fail to qualify as a REIT in any tax year, then:

•

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

•

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

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

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

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

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

The REIT provisions of the Code may substantially limit our ability to hedge mortgage-backed securities

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

Complying with REIT requirements may force us to liquidate otherwise attractive investments or to make
investments inconsistent with our business plan.

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

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

As a REIT, we must distribute 90% of our annual taxable income (subject to certain adjustments) to our

stockholders. From time to time, we may generate taxable income greater than our net income for financial
reporting purposes from, among other things, amortization of capitalized purchase premiums, or our taxable

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

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

As long as we own 100% of Belvedere Trust’s outstanding stock, Belvedere Trust will be treated as a
qualified REIT subsidiary for federal income tax purposes. As such, for federal income tax purposes, we will not
be treated as owning stock in Belvedere Trust and, Belvedere Trust’s assets, liabilities and income will generally
be treated as our assets, liabilities and income for purposes of the REIT qualification tests described above under
“Certain Federal Income Tax Considerations.” If, however, we do not own 100% of Belvedere Trust’s
outstanding stock, and Belvedere Trust does not qualify as a REIT, a qualified REIT subsidiary or a taxable
REIT subsidiary, we will lose our REIT status if, at the end of any calendar quarter, the value of our Belvedere
Trust securities exceeds 5% of the value of our total assets or we own more than 10% of the value or voting
power of Belvedere Trust’s outstanding securities. If we fail to satisfy the 5% test or the 10% test at the end of
any calendar quarter, a 30-day “cure” period may apply following the close of the quarter. If we make an election
to treat Belvedere Trust as a taxable REIT subsidiary, the total value of any securities we own in Belvedere Trust
and all of our other taxable REIT subsidiaries, if any, may not exceed 20% of the value of our total assets at the
end of any calendar quarter. Since Belvedere Trust may elect to be taxed as a REIT in the future, however, we do
not intend to make a taxable REIT subsidiary election for Belvedere Trust. In the event of a more than de
minimis failure of the 20% asset test occurring in taxable years after 2004, we will not lose our REIT status as
long as (i) the failure was due to reasonable cause and not to willful neglect, (ii) we dispose of the assets causing
the failure or otherwise comply with the 20% asset test within six months after the last day of the applicable
quarter in which we identify such failure, and (iii) we pay a tax equal to the greater of $50,000 or 35% of the net
income from the non-qualifying assets during the period in which we failed the 20% asset test. If there is more
than a de minimis failure of the 20% asset test occurring in taxable years after 2004 and we do not satisfy the
requirements described in the preceding sentence, we would lose our REIT status.

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

Though Belvedere Trust was formed as a qualified REIT subsidiary, it may elect to be taxed as a REIT in

the future, possibly as early as its taxable year ending December 31, 2005. Although Belvedere Trust expects to
operate in a manner to permit it to qualify as a REIT if and when it makes a REIT election and to continue to
maintain such qualification, the actual results of Belvedere Trust’s operations for any particular taxable year may
not satisfy these requirements. If Belvedere Trust fails to qualify for taxation as a REIT in any taxable year after
it makes a REIT election, and the relief provisions of the Code do not apply, Belvedere Trust will be required to
pay tax on Belvedere Trust’s taxable income in that taxable year and all subsequent taxable years at regular
corporate rates. Distributions to us in any year in which Belvedere Trust fails to qualify as a REIT will not be
deductible by Belvedere Trust. As a result, we anticipate that Belvedere Trust’s failure to qualify as a REIT after
it makes a REIT election would reduce the cash available for distribution to us. Unless entitled to relief under
specific statutory provisions, if Belvedere Trust fails to maintain its REIT status after it makes a REIT election,
Belvedere Trust will also be disqualified from taxation as a REIT for the four taxable years following the year in
which it loses its qualification.

We conduct a portion of our business through taxable REIT subsidiaries, which could have adverse tax
consequences.

We conduct a portion of our business, including securitizations, through taxable REIT subsidiaries, such as

Belvedere Trust Finance Corporation. Despite our qualification as a REIT, our taxable REIT subsidiaries must
pay federal income tax on their taxable income. In addition, we must comply with various tests to continue to
qualify as a REIT for federal income tax purposes, and our income from, and investments in, our taxable REIT
subsidiaries generally do not constitute permissible income and investments for these tests. While we attempt to
ensure that our dealings with our taxable REIT subsidiaries will not adversely affect our REIT qualification, no
assurance can be given that we will successfully achieve that result. Furthermore, we may be subject to a 100%
penalty tax, or our taxable REIT subsidiaries may be denied deductions, to the extent our dealings with our
taxable REIT subsidiaries are not deemed to be arms’-length in nature.

The tax imposed on REITs engaging in “prohibited transactions” will limit our ability to engage in
transactions, including certain methods of securitizing loans, that would be treated as sales for federal income
tax purposes.

A REIT’s net income from prohibited transactions is subject to a 100% tax. In general, prohibited

transactions are sales or other dispositions of property, other than foreclosure property, but including any
mortgage loans, held in inventory primarily for sale to customers in the ordinary course of business. We might be
subject to this tax if we were to sell a loan or securitize loans in a manner that was treated as a sale of such
inventory for federal income tax purposes. Therefore, in order to avoid the prohibited transactions tax, we may
choose not to engage in certain sales of loans other than through a taxable REIT subsidiary, and may limit the
structures we utilize for our securitization transaction even though such sales or structures might otherwise be
beneficial for us. In addition, this prohibition may limit our ability to restructure our investment portfolio of
mortgage loans from time to time even if we believe that it would be in our best interest to do so.

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

We believe that we conduct our business in a manner that allows us to avoid being regulated as an

investment company under the Investment Company Act of 1940, as amended. If we fail to continue to qualify
for an exemption from registration as an investment company, our ability to use leverage would be substantially
reduced and we would be unable to conduct our business as planned. The Investment Company Act exempts
entities that are primarily engaged in the business of purchasing or otherwise acquiring “mortgages and other
liens on and interests in real estate.” Under the SEC’s current interpretation, qualification for this exemption
generally requires us to maintain at least 55% of our assets directly in qualifying real estate interests.
Mortgage-backed securities that do not represent all the certificates issued with respect to an underlying pool of
mortgages may be treated as securities separate from the underlying mortgage loans and thus may not qualify for
purposes of the 55% requirement. Therefore, our ownership of these mortgage-backed securities is limited by the
Investment Company Act. In meeting the 55% requirement under the Investment Company Act, we treat as
qualifying interests mortgage-backed securities issued with respect to an underlying pool for which we hold all
issued certificates. If the SEC or its staff adopts a contrary interpretation, we could be required to sell a
substantial amount of our mortgage-backed securities under potentially adverse market conditions. Further, in
order to maintain our exemption from registration as an investment company, we may be precluded from
acquiring mortgage-backed securities whose yield is somewhat higher than the yield on mortgage-backed
securities that could be purchased in a manner consistent with the exemption.

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

In general, dividend income that a tax-exempt entity receives from us should not constitute unrelated
business taxable income as defined in Section 512 of the Internal Revenue Code. If we realize excess inclusion
income and allocate it to stockholders, however, then this income would be fully taxable as unrelated business

taxable income under Section 512 of the Internal Revenue Code. If the stockholder is foreign, it would generally
be subject to United States federal income tax withholding on this income without reduction pursuant to any
otherwise applicable income tax treaty. United States stockholders would not be able to offset such income with
their operating losses.

We generally structure our borrowing arrangements in a manner designed to avoid generating significant
amounts of excess inclusion income. However, excess inclusion income could result if we held a residual interest
in a real estate mortgage investment conduit, or REMIC. Excess inclusion income also may be generated if we
were to issue debt obligations with two or more maturities and the terms of the payments or these obligations
bore a relationship to the payments that we received on our mortgage loans or mortgage-backed securities
securing those debt obligations. For example, we may engage in non-REMIC collateralized mortgage
obligations, or CMO, securitizations. We also enter into various repurchase agreements that have differing
maturity dates and afford the lender the right to sell any pledged mortgage securities if we default on our
obligations. The Internal Revenue Service may determine that these transactions give rise to excess inclusion
income that should be allocated among our stockholders. We may invest in equity securities of other REITs and
it is possible that we might receive excess inclusion income from those investments. Some types of entities,
including, without limitation, voluntarily employee benefit associations and entities that have borrowed funds to
acquire their shares of our stock, may be required to treat a portion of or all of the dividends they receive from us
as unrelated business taxable income.

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

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

Additional Risk Factors

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

We intend to seek to raise additional capital from time to time if we determine that it is in our best interests

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

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

We intend to pay quarterly dividends and to make distributions to our common stockholders in amounts such

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

If we raise additional capital, our earnings per share and dividends per share may decline since we may not

be able to invest all of the new capital during the quarter in which additional shares are sold and possibly the
entire following calendar quarter.

Our future offerings of debt or preferred equity securities may adversely affect the value of our Series A
Preferred Stock.

Our charter provides that we may issue up to 20 million shares of preferred stock in one or more series. In
addition to our outstanding Series A Preferred Stock, we currently have an agreement with Cantor pursuant to
which we may issue up to 2.0 million shares of our Series A Preferred Stock. The issuance of additional preferred
stock on parity with or senior to our Series A Preferred Stock could have the effect of diluting the amounts we
may have available for distribution to holders of our Series A Preferred Stock. In addition, our Series A Preferred
Stock will be subordinated to all our existing and future debt. None of the provisions relating to our Series A
Preferred Stock contains any provisions affording the holders of our Series A Preferred Stock protection in the
event of a highly leveraged or other transaction, including a merger or the sale, lease or conveyance of all or
substantially all our assets or business, that might adversely affect the holders of our Series A Preferred Stock.

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

For the purpose of preserving our REIT qualification and for other reasons, our charter prohibits direct or

constructive ownership by any person of more than 9.8% of the lesser of the total number or value of the
outstanding shares of our common stock or more than 9.8% of the outstanding shares of our preferred stock. Our
charter’s constructive ownership rules are complex and may cause the outstanding stock owned by a group of
related individuals or entities to be deemed to be constructively owned by one individual or entity. As a result,
the acquisition of less than 9.8% of the outstanding stock by an individual or entity could cause that individual or
entity to own constructively in excess of 9.8% of the outstanding stock, and thus be subject to our charter’s
ownership limit. Any attempt to own or transfer shares of our common or preferred stock in excess of the
ownership limit without the consent of the board of directors shall be void, and will result in the shares being
transferred by operation of law to a charitable trust. Our board of directors has granted an unrelated third party
institutional investor an exemption from the 9.8% ownership limitation as set forth in our charter documents.
This exemption permits this entity to hold up to 170,400 preferred shares or 9.8% of our outstanding shares of
preferred stock, whichever is greater.

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

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

•

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

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

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

• Maryland control share acquisition statute. Maryland law limits the voting rights of “control shares” of

a corporation in the event of a “control share acquisition.”

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

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

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

In the future, we may attempt to increase our capital resources by making additional offerings of debt or

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

Our charter provides that we may issue up to 20 million shares of preferred stock in one or more series. The

issuance of additional preferred stock on parity with or senior to the Series A Preferred Stock could have the
effect of diluting the amounts we may have available for distribution to holders of the Series A Preferred Stock.
The Series A Preferred Stock will be subordinated to all our existing and future debt. Thus, our Series A
Preferred Stockholders bear the risk of our future offerings reducing the market price of our Series A Preferred
Stock.

Item 7A. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK

We seek to manage the interest rate, market value, liquidity, prepayment and credit risks inherent in all

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

Interest Rate Risk

We primarily invest in adjustable-rate, hybrid and fixed-rate mortgage-backed securities. Hybrid mortgages

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

Adjustable-rate mortgage-backed assets are typically subject to periodic and lifetime interest rate caps that

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

We fund the purchase of a substantial portion of our adjustable-rate mortgage-backed debt securities with

borrowings that have interest rates based on indices and repricing terms similar to, but of somewhat shorter
maturities than, the interest rate indices and repricing terms of our mortgage assets. Thus, we anticipate that in
most cases the interest rate indices and repricing terms of our mortgage assets and our funding sources will not
be identical, thereby creating an interest rate mismatch between assets and liabilities. During periods of changing
interest rates, such interest rate mismatches could negatively impact our net interest income, dividend yield and
the market price of our common stock.

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

Our adjustable-rate mortgage-backed securities and borrowings reset at various different dates for the

specific asset or obligation. In general, the repricing of our debt obligations occurs more quickly than on our
assets. Therefore, on average, our cost of funds may rise or fall more quickly than does our earnings rate on the
assets.

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

twelve-month interest rates varies.

At December 31, 2004, our agency mortgage-backed securities and related borrowings will prospectively

reprice based on the following time frames (dollar amounts in thousands):

Investment Type/Rate Reset Dates:
Fixed-rate investments . . . . . . . . . . . . . . . . . . . .

Adjustable-Rate Investments/ Obligations:
Less than 3 months . . . . . . . . . . . . . . . . . . . . . . .
Greater than 3 months and less than 1 year . . . .
Greater than 1 year and less than 2 years . . . . . .
Greater than 2 years and less than 3 years . . . . .
Greater than 3 years and less than 5 years . . . . .

Assets

Borrowings

Amount

Percentage of Total
Investments

Amount

Percentage of Total
Borrowings

(amounts in thousands)

$ 201,515

4.4%

—

335,616
1,106,030
902,916
1,504,897
537,567

7.3%
24.1%
19.7%
32.8%
11.7%

1,540,060
2,165,870
467,000
—
—

36.9%
51.9%
11.2%
—
—

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$4,588,541

100.0%

$4,172,930

100.0%

Market Value Risk

Substantially all of our mortgage-backed securities and equity securities are classified as available-for-sale

assets. As such, they are reflected at fair value (i.e., market value) with the periodic adjustment to fair value
reflected as part of Accumulated Other Comprehensive Income that is included in the equity section of our
balance sheet. The market value of our assets can fluctuate due to changes in interest rates and other factors.

Liquidity Risk

Our primary liquidity risk arises from financing long-maturity mortgage-backed securities with short-term

debt. The interest rates on our borrowings generally adjust more frequently than the interest rates on our
adjustable-rate mortgage-backed securities. For example, at December 31, 2004, our agency adjustable-rate
mortgage-backed securities had a weighted average term to next rate adjustment of approximately 23 months,
while our borrowings had a weighted average term to next rate adjustment of 184 days. After adjusting for
interest rate swap transactions, the weighted average term to next rate adjustment was 304 days. Accordingly, in
a period of rising interest rates, our borrowing costs will usually increase faster than our interest earnings from
mortgage-backed securities. As a result, we could experience a decrease in net income or a net loss during these
periods. Our assets that are pledged to secure short-term borrowings are high-quality, liquid assets. As a result,
we have not had difficulty rolling over our short-term borrowings as they mature. There can be no assurance that
we will always be able to roll over our short-term debt.

At December 31, 2004, we had unrestricted cash of $3.04 million available to meet margin calls on short-

term borrowings that could be caused by asset value declines or changes in lender collateralization requirements.

Prepayment Risk

Prepayments are the full or partial repayment of principal prior to the original term to maturity of a
mortgage loan and typically occur due to refinancing of mortgage loans. Prepayment rates on mortgage-related
securities vary from time to time and may cause changes in the amount of our net interest income. Prepayments
of adjustable-rate mortgage loans usually can be expected to increase when mortgage interest rates fall below the
then-current interest rates on such loans and decrease when mortgage interest rates exceed the then-current
interest rate on such loans, although such effects are not entirely predictable. Prepayment rates may also be
affected by the conditions in the housing and financial markets, general economic conditions and the relative
interest rates on fixed-rate and adjustable-rate mortgage loans underlying mortgage-backed securities. The
purchase prices of mortgage-backed securities are generally based upon assumptions regarding the expected
amounts and rates of prepayments. Where slow prepayment assumptions are made, we may pay a premium for

mortgage-backed securities. To the extent such assumptions differ from the actual amounts of prepayments, we
could experience reduced earnings or losses. The total prepayment of any mortgage-backed securities purchased
at a premium by us would result in the immediate write-off of any remaining capitalized premium amount and a
reduction of our net interest income by such amount. Finally, in the event that we are unable to acquire new
mortgage-backed securities to replace the prepaid mortgage-backed securities, our financial condition, cash flows
and results of operations could be harmed.

We often purchase mortgage-backed securities that have a higher interest rate than the market interest rate at

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

Tabular Presentation

Anworth Agency Mortgage-Backed Securities

The information presented in the table below projects the impact of sudden changes in interest rates on
Anworth’s annual projected net income and Net Assets (excluding Belvedere Trust’s operations) as more fully
discussed below based on investments in place at December 31, 2004, and includes all of Anworth’s interest
rate-sensitive assets, liabilities and hedges such as interest rate swap agreements. Changes in Net Assets equals
the change in value of our assets that Anworth carries at fair value rather than at historical amortized cost and any
change in the value of any derivative instruments or hedges, such as interest rate swap agreements. Anworth
acquires interest rate-sensitive assets and funds them with interest rate-sensitive liabilities. Anworth generally
plans to retain such assets and the associated interest rate risk to maturity.

Change in Interest Rates

Projected Percentage Change
in Net Interest Income

Projected Percentage Change
in Net Assets

–2.0%
–1.0%
0%
1.0%
2.0%

–150%
–106%
—
–41%
–75%

0.4%
0.4%
—
–1.4%
–3.5%

When interest rates are shocked, prepayment assumptions are adjusted based on management’s best estimate
of the effects of changes in interest rates on prepayment speeds. For example, under current market conditions, a
100 basis point decline in interest rates is estimated to result in a 73% increase in the prepayment rate of our
mortgage-backed securities portfolio. The base interest rate scenario assumes interest rates at December 31,
2004. Actual results could differ significantly from those estimated in the table.

The above table includes the effect of interest rate swap agreements. At December 31, 2004, the aggregate
notional amount of the interest rate swap agreements was $400 million and the average maturity was 3.6 years.
The information presented in the table below projects the impact of sudden changes in interest rates on
Anworth’s annual projected net income and net assets (excluding Belvedere Trust’s operations) and excludes the
effect of the interest rate swap agreements.

Change in Interest Rates

Projected Percentage Change
in Net Interest Income

Projected Percentage Change
in Net Assets

–2.0%
–1.0%
0%
1.0%
2.0%

–118.4%
–87.5%
—
–46.4%
–86.5%

1.0%
0.7%
—
–1.7%
–4.0%

Belvedere Trust

The information presented in the table below projects the impact of sudden changes in interest rates on

Belvedere Trust’s annual projected net income and Net Assets as more fully discussed below based on
investments in place at December 31, 2004. Changes in Net Assets equals the change in value of our assets that
Belvedere Trust carries at fair value rather than at historical amortized cost, and any change in the value of any
derivative instruments or hedges, such as interest rate swap agreements and Eurodollar futures contracts.
Belvedere Trust’s residential real estate loans are carried at historical amortized cost and therefore are not
included in Net Assets in the table below. Belvedere Trust acquires interest rate-sensitive assets and funds them
with interest rate-sensitive liabilities. Belvedere Trust generally plans to retain such assets and the associated
interest rate risk to maturity.

Change in Interest Rates

Projected Percentage Change
in Net Interest Income

Projected Percentage Change
in Net Assets

–2.0%
–1.0%
0%
1.0%
2.0%

16.8%
6.2%
—
–14.5%
–37.0%

1.6%
0.9%
—
–2.0%
–4.8%

When interest rates are shocked, prepayment assumptions are adjusted based on management’s best estimate
of the effects of changes in interest rates on prepayment speeds. For example, under current market conditions, a
100 basis point decline in interest rates is estimated to result in an increase from 21.7% to 30.3% in the
prepayment rate of Belvedere Trust’s mortgage-related assets (which include those assets that have been
securitized). The base interest rate scenario assumes interest rates at December 31, 2004. Actual results could
differ significantly from those estimated in the table.

General

Many assumptions are made to present the information in the above tables, as such, there can be no
assurance that assumed events will occur or that other events will not occur that would affect the outcomes;
therefore, the above tables and all related disclosures constitute forward-looking statements. The analyses
presented utilize assumptions and estimates based on management’s judgment and experience. Furthermore,
future sales, acquisitions and restructuring could materially change the interest rate risk profile for Anworth and
Belvedere Trust. The tables quantify the potential changes in net income and net asset value should interest rates
immediately change (are “shocked”). The results of interest rate shocks of plus and minus 100 and 200 basis
points are presented. The cash flows associated with the portfolio of mortgage-related assets for each rate shock
are calculated based on a variety of assumptions, including prepayment speeds, time until coupon reset, yield on
future acquisitions, slope of the yield curve and size of the portfolio. Assumptions made on the interest-rate
sensitive liabilities, which are repurchase agreements, include anticipated interest rates (no negative rates are
utilized), collateral requirements as a percent of the repurchase agreement and amount of borrowing.
Assumptions made in calculating the impact on net asset value of interest rate shocks include interest rates,
prepayment rates and the yield spread of mortgage-related assets relative to prevailing interest rates.

Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY INFORMATION

The financial statements and related financial information required to be filed hereunder are indexed under

Item 15 of this report and are incorporated herein by reference.

Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND

FINANCIAL DISCLOSURE

On December 8, 2003, the audit committee of our board of directors voted to dismiss

PricewaterhouseCoopers LLP as our independent accountants and to engage the services of BDO Seidman, LLP
to serve as our independent public accountants for the 2003 fiscal year.

PricewaterhouseCoopers’ reports on our consolidated financial statements for each of the years ended
December 31, 2002 and 2001 did not contain an adverse opinion or disclaimer of opinion, nor were such reports
qualified or modified as to uncertainty, audit scope, or accounting principles. In connection with its audits for the
fiscal years ended December 31, 2002 and 2001 and through December 8, 2003, there were no disagreements
with PricewaterhouseCoopers on any matter of accounting principles or practices, financial statement disclosure,
or auditing scope or procedure, which, if not resolved to the satisfaction of PricewaterhouseCoopers, would have
caused PricewaterhouseCoopers to make reference to the subject matter of the disagreement(s) in connection
with its reports on our financial statements as of December 31, 2002 and 2001 and for the years then ended.
During the fiscal years ended December 31, 2002 and 2001 and through December 8, 2003, there were no
“reportable events” requiring disclosure pursuant to Item 304 (a) (1) (v) of Regulation S-K.

We requested and PricewaterhouseCoopers furnished us with a letter addressed to the SEC stating whether or

not it agrees with the statements made in the paragraph above. A copy of the letter from PricewaterhouseCoopers
dated December 8, 2003 was filed as Exhibit 16.1 to our Current Report on Form 8-K dated December 8, 2003.

Effective December 8, 2003, we engaged BDO Seidman as our independent accountants. During the two years

ended December 31, 2002 and through December 8, 2003, neither we nor anyone on our behalf consulted BDO
Seidman regarding either the application of accounting principles to a specified transaction, either completed or
proposed, or the type of audit opinion that might be rendered on our consolidated financial statements, nor has BDO
Seidman provided to us a written report or oral advice regarding such principles or audit opinion.

Item 9A. CONTROLS AND PROCEDURES

We maintain disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e)
under the Exchange Act), designed to ensure that information required to be disclosed by us in the reports that it
files or submits under the Exchange Act is recorded, processed, summarized and reported on a timely basis.

Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has
evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this
report. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that,
as of the end of such period, our disclosure controls and procedures are effective.

Management Report on Internal Control Over Financial Reporting

The management of Anworth Mortgage Asset Corporation is responsible for establishing and maintaining

adequate internal control over financial reporting. Anworth’s internal control system was designed to provide
reasonable assurance to the company’s management and board of directors regarding the preparation and fair
presentation of prepared financial statements.

All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those

systems determined to be effective can provide only reasonable assurance with respect to financial statement
preparation and presentation.

Anworth’s management assessed the effectiveness of the company’s internal control over financial reporting

as of December 31, 2004. In making this assessment, it used the criteria set forth by the Committee of
Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework.
Based on our assessment, we believe that, as of December 31, 2004, the company’s internal control over
financial reporting is effective based on those criteria.

Report of Independent Registered Public Accounting Firm on
Internal Control over Financial Reporting

To the Board of Directors and Stockholders of Anworth Mortgage Asset Corporation
Santa Monica, California

We have audited management’s assessment, included in the accompanying Management’s Report on
Internal Control Over Financial Reporting, that Anworth Mortgage Asset Corporation (Anworth) maintained
effective internal control over financial reporting as of December 31, 2004, based on criteria established in
Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway
Commission (the COSO criteria). Anworth’s management is responsible for maintaining effective internal
control over financial reporting and for its assessment of the effectiveness of internal control over financial
reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the
effectiveness of Anworth’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight
Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance
about whether effective internal control over financial reporting was maintained in all material respects. Our
audit included obtaining an understanding of internal control over financial reporting, evaluating management’s
assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such
other procedures as we considered necessary in the circumstances. We believe that our audit provides a
reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance
regarding the reliability of financial reporting and the preparation of financial statements for external purposes in
accordance with generally accepted accounting principles. A company’s internal control over financial reporting
includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail,
accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable
assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance
with generally accepted accounting principles, and that receipts and expenditures of the company are being made
only in accordance with authorizations of management and directors of the company; and (3) provide reasonable
assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the
company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect
misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that
controls may become inadequate because of changes in conditions, or that the degree of compliance with the
policies or procedures may deteriorate.

In our opinion, management’s assessment that Anworth maintained effective internal control over financial
reporting as of December 31, 2004, is fairly stated, in all material respects, based on the COSO criteria. Also, in
our opinion, Anworth maintained, in all material respects, effective internal control over financial reporting as of
December 31, 2004, based on the COSO criteria.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board

(United States), the consolidated balance sheets of Anworth Mortgage Asset Corporation, as of December 31,
2004 and 2003 and the related consolidated statements of income, stockholders’ equity, cash flows and
comprehensive income for each of the two years in the period ended December 31, 2004 of Anworth and our
report dated March 15, 2005 expressed an unqualified opinion thereon.

Los Angeles, California
March 15, 2005

Item 9B. OTHER INFORMATION

The Company’s current report on Form 8-K filed on February 1, 2005 reported that Charles Siegel is our

Principal Accounting Officer. Thad M. Brown is our Principal Accounting Officer.

PART III

Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The information required by this Item is incorporated herein by reference from the information under the

captions entitled “Election of Directors—Information Regarding Nominees for Director,” “Executive Officers”
and “Section 16(a) Beneficial Ownership Reporting Compliance” in our definitive proxy statement to be filed
with the SEC no later than April 30, 2005.

Item 11. EXECUTIVE COMPENSATION

The information required by this Item is incorporated by reference from the information under the caption

entitled “Executive Compensation” in our definitive proxy statement to be filed with the SEC no later than
April 30, 2005.

Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The information required by this Item is incorporated by reference from the information under the caption
entitled “Security Ownership of Certain Beneficial Owners and Management” in our definitive proxy statement
to be filed with the SEC no later than April 30, 2005.

Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

The information required by this Item is incorporated by reference from the information under the caption
entitled “Certain Transactions and Relationships” in our definitive proxy statement to be filed with the SEC no
later than April 30, 2005.

Item 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES

The information required by this Item is incorporated by reference from the information under the caption
entitled “Principal Accountant Fees and Services” in our definitive proxy statement to be filed with the SEC no
later than April 30, 2005.

PART IV

Item 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

(a) Documents filed as part of this report:

(1) The following financial statements of the Company are included in Part II, Item 8 of this Annual Report

on Form 10-K:

•
•
•
•

•

Report of Independent Registered Public Accounting Firm, BDO Seidman, LLP;
Report of Independent Public Registered Accounting Firm, PricewaterhouseCoopers LLP;
Consolidated Balance Sheets as of December 31, 2004 and December 31, 2003;
Consolidated Statements of Income: Years Ended December 31, 2004, December 31, 2003 and
December 31, 2002;
Consolidated Statements of Stockholders’ Equity: Years Ended December 31, 2004, December 31,
2003 and December 31, 2002;
Consolidated Statements of Cash Flows: Years Ended December 31, 2004, December 31, 2003 and
December 31, 2002; and
Notes to Consolidated Financial Statements.

(2) Schedules to financial statements:

All financial statement schedules have been omitted because they are either inapplicable or the

information required is provided in the Company’s Financial Statements and Notes thereto, included in Part
II, Item 8 of this Annual Report on Form 10-K.

(3) The following exhibits are filed herewith:

Exhibit
Number

Description

3.1

3.2

3.3

3.4

3.5

4.1

4.2

Amended Articles of Incorporation of Anworth (incorporated by reference from our Registration
Statement on Form S-11, Registration No. 333-38641, which became effective under the Securities
Act of 1933 on March 12, 1998)

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

Articles Supplementary for Series A Cumulative Preferred Stock (incorporated by reference from our
Current Report on Form 8-K filed with the Securities and Exchange Commission on November 3,
2004)

Articles Supplementary for Series A Cumulative Preferred Stock (incorporated by reference from our
Current Report on Form 8-K filed with the Securities and Exchange Commission on January 21,
2005)

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

Specimen Common Stock Certificate (incorporated by reference from our Registration Statement on
Form S-11, Registration No. 333-38641, which became effective under the Securities Act of 1933 on
March 12, 1998)

Specimen Series A Cumulative Preferred Stock Certificate (incorporated by reference from our
Current Report on Form 8-K filed with the Securities and Exchange Commission on November 3,
2004)

10.1

2004 Equity Compensation Plan (incorporated by reference from our Definitive Proxy Statement
filed pursuant to Section 14(a) of the Securities Exchange Act of 1934, as filed with the Securities
and Exchange Commission on April 26, 2004)

Exhibit
Number

10.2

10.3

10.4

10.5

10.6

10.7

10.8

10.9

10.10

10.11

10.12

10.13

10.14

10.15

Description

2003 Dividend Reinvestment and Stock Purchase Plan (incorporated by reference from Post-
Effective Amendment No. 1 to our Registration Statement on Form S-3, Registration No.
333-110744, which became effective under the Act on February 20, 2004)
2002 Incentive Compensation Plan (incorporated by reference from our Definitive Proxy Statement
filed pursuant to Section 14(a) of the Securities Exchange Act of 1934, as filed with the Securities
Exchange Commission on May 17, 2002)
Agreement and Plan of Merger dated April 18, 2002 by and among Anworth, Anworth Mortgage
Advisory Corporation (the “Manager”) and the shareholder of the Manager (incorporated by
reference from our Definitive Proxy Statement filed pursuant to Section 14(a) of the Securities
Exchange Act of 1934, as filed with the Securities Exchange Commission on May 17, 2002)
Employment Agreement dated January 1, 2002, between the Manager and Lloyd
McAdams(incorporated by reference from our Quarterly Report on Form 10-Q for the quarter ended
June 30, 2002, as filed with the Securities and Exchange Commission on August 14, 2002)
Employment Agreement dated January 1, 2002, between the Manager and Heather U. Baines
(incorporated by reference from our Quarterly Report on Form 10-Q for the quarter ended June 30,
2002, as filed with the Securities and Exchange Commission on August 14, 2002)
Employment Agreement dated January 1, 2002, between the Manager and Joseph E. McAdams
(incorporated by reference from our Quarterly Report on Form 10-Q for the quarter ended June 30,
2002, as filed with the Securities and Exchange Commission on August 14, 2002)
Addendum to Employment Agreement dated April 18, 2002, among Anworth, the Manager and
Lloyd McAdams (incorporated by reference from our Quarterly Report on Form 10-Q for the quarter
ended June 30, 2002, as filed with the Securities and Exchange Commission on August 14, 2002)
Addendum to Employment Agreement dated April 18, 2002, among Anworth, the Manager and
Heather U. Baines (incorporated by reference from our Quarterly Report on Form 10-Q for the
quarter ended June 30, 2002, as filed with the Securities and Exchange Commission on August 14,
2002)
Addendum to Employment Agreement dated April 18, 2002, among Anworth, the Manager and
Joseph E. McAdams (incorporated by reference from our Quarterly Report on Form 10-Q for the
quarter ended June 30, 2002, as filed with the Securities and Exchange Commission on August 14,
2002)
Second Addendum to Employment Agreement dated as of May 28, 2004 between Anworth and
Lloyd McAdams (incorporated by reference from our Quarterly Report on Form 10-Q for the quarter
ended June 30, 2004, as filed with the Securities and Exchange Commission on August 9, 2004)
Second Addendum to Employment Agreement dated as of June 13, 2002 by and among Anworth and
Joseph E. McAdams (incorporated by reference from our Quarterly Report on Form 10-Q for the
quarter ended June 30, 2002, as filed with the Securities and Exchange Commission on August 14,
2002)
Third Addendum to Employment Agreement dated as of May 28, 2004, between Anworth and
Joseph E. McAdams (incorporated by reference from our Quarterly Report on Form 10-Q for the
quarter ended June 30, 2004, as filed with the Securities and Exchange Commission on August 9,
2004)
Sublease dated June 13, 2002, between Anworth and Pacific Income Advisers, Inc. (incorporated by
reference from our Quarterly Report on Form 10-Q for the quarter ended June 30, 2002, as filed with
the Securities and Exchange Commission on August 14, 2002)
Amendment to Sublease dated July 8, 2003 between Anworth and Pacific Income Advisers, Inc.
(incorporated by reference from our Quarterly Report on Form 10-Q for the quarter ended June 30,
2003, as filed with the Securities and Exchange Commission on August 8, 2003)

Exhibit
Number

10.16

10.17

10.18

10.19

10.20

10.21

10.22

Description

Administrative Agreement dated October 14, 2002, between Anworth and Pacific Income Advisers,
Inc. (incorporated by reference from our Quarterly Report on Form 10-Q for the quarter ended
September 30, 2002, as filed with the Securities and Exchange Commission on November 14, 2002)

Deferred Compensation Plan (incorporated by reference from our Annual Report on Form 10-K for
the year ended December 31, 2002, as filed with the Securities and Exchange Commission on March
26, 2003)

BT Management Company, L.L.C. (“BT Management”) Operating Agreement dated November 3,
2003 (incorporated by reference from our Quarterly Report on Form 10-Q for the quarter ended
September 30, 2003, as filed with the Securities and Exchange Commission on November 13, 2003)

Management Agreement dated November 3, 2003 between BT Management and Belvedere Trust
Mortgage Corporation (incorporated by reference from our Quarterly Report on Form 10-Q for the
quarter ended September 30, 2003, as filed with the Securities and Exchange Commission on
November 13, 2003)

Employment Agreement dated November 3, 2003 between BT Management and Claus Lund
(incorporated by reference from our Quarterly Report on Form 10-Q for the quarter ended September
30, 2003, as filed with the Securities and Exchange Commission on November 13, 2003)

Employment Agreement dated November 3, 2003 between BT Management and Russell J.
Thompson (incorporated by reference from our Quarterly Report on Form 10-Q for the quarter ended
September 30, 2003, as filed with the Securities and Exchange Commission on November 13, 2003)

Amended and Restated Sales Agreement dated January 19, 2005 between Anworth and Cantor
Fitzgerald & Co. (incorporated by reference from our Current Report on Form 8-K filed with the
Securities and Exchange Commission on January 21, 2005)

10.23

Sublease dated January 6, 2005 between Belvedere Trust Mortgage Corporation and Keefe,

21.1

23.1

23.2

31.1

31.2

32.1

32.2

Bruyette & Woods, Inc.

List of Subsidiaries

Consent of BDO Seidman, LLP

Consent of PricewaterhouseCoopers LLP

Certification of the Chief Executive Officer, as required by Rule 13a-14(a) of the Securities
Exchange Act of 1934

Certification of the Chief Financial Officer, as required by Rule 13a-14(a) of the Securities Exchange
Act of 1934

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

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

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant

has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

DATED: March 15, 2005

ANWORTH MORTGAGE ASSET CORPORATION

/s/

JOSEPH LLOYD MCADAMS
Joseph Lloyd McAdams
Chairman of the Board, President and
Chief Executive Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by

the following persons on behalf of the registrant and in the capacities and on the dates indicated.

Signature

Title

Date

/s/

JOSEPH LLOYD MCADAMS
Joseph Lloyd McAdams

Chairman of the Board, President and
Chief Executive Officer (Principal
Chief Executive)

March 15, 2005

/s/ THAD M. BROWN

Chief Financial Officer (Principal

March 15, 2005

Thad M. Brown

Accounting Officer)

/s/

JOSEPH E. MCADAMS
Joseph E. McAdams

Executive Vice President Chief

Investment Officer and Director

March 15, 2005

/s/ CHARLES H. BLACK

Director

March 15, 2005

Charles H. Black

/s/

JOE E. DAVIS
Joe E. Davis

Director

March 15, 2005

/s/ CHARLES F. SMITH

Director

March 15, 2005

Charles F. Smith

/s/ LEE A. AULT, III

Lee A. Ault, III

Director

March 15, 2005

ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

Report of Independent Registered Public Accounting Firm BDO Seidman, LLP . . . . . . . . . . . . . . . . . . . . . .
Report of Independent Public Registered Accounting Firm PricewaterhouseCoopers LLP . . . . . . . . . . . . . .
Consolidated Balance Sheets as of December 31, 2004 and 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Consolidated Statements of Income for the Years Ended December 31, 2004, 2003 and 2002 . . . . . . . . . . .
Consolidated Statements of Stockholders’ Equity for the Years Ended December 31, 2004, 2003 and

2002 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Consolidated Statements of Cash Flows for the Years Ended December 31, 2004, 2003 and 2002 . . . . . . . .
Consolidated Statements of Comprehensive Income for the Years Ended December 31, 2004, 2003 and

2002 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Notes to Consolidated Financial Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Page

F-2
F-3
F-4
F-5

F-6
F-7

F-8
F-9

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Board of Directors and Stockholders
Anworth Mortgage Asset Corporation
Santa Monica, California

We have audited the accompanying consolidated balance sheets of Anworth Mortgage Asset Corporation
and subsidiaries (the Company) as of December 31, 2004 and 2003 and the related consolidated statements of
income, stockholders’ equity, cash flows and comprehensive income for the years then ended. These
consolidated 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 the standards of the Public Company Accounting Oversight
Board (United States). 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 financial statements. An audit also includes
assessing the accounting principles used and significant estimates 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, the consolidated financial statements referred to above present fairly, in all material respects,

the financial position of Anworth Mortgage Asset Corporation and subsidiaries at December 31, 2004 and 2003
and the results of its operations, cash flows and comprehensive income for the years then ended in conformity
with accounting principles generally accepted in the United States of America.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board

(United States), the effectiveness of Anworth Mortgage Asset Corporation’s internal control over financial
reporting as of December 31, 2004, based on criteria established in Internal Control—Integrated Framework
issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report
dated March 15, 2005 expressed an unqualified opinion thereon.

BDO Seidman, LLP
Los Angeles, California
March 15, 2005

F-2

REPORT OF INDEPENDENT PUBLIC REGISTERED ACCOUNTING FIRM

To the Board of Directors and Stockholders of
Anworth Mortgage Asset Corporation:

In our opinion, the statements of income, of stockholders’ equity, of comprehensive income and of cash
flows for the year ended December 31, 2002 present fairly, in all material respects, the results of operations and
cash flows of Anworth Mortgage Asset Corporation for the year ended December 31, 2002, in conformity with
accounting principles generally accepted in the United States of America. 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 audit. We conducted our audit of these statements in accordance with the standards of
the Public Company Accounting Oversight Board (United States). 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 financial statements, assessing the accounting principles used and significant estimates made by management,
and evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis
for our opinion.

/s/ PricewaterhouseCoopers LLP

PricewaterhouseCoopers LLP
Los Angeles, CA
January 18, 2003

F-3

ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS
(in thousands, except per share amounts)

Agency mortgage-backed securities:

ASSETS

Agency mortgage-backed securities pledged to counterparties at fair value . . . .
Agency mortgage-backed securities at fair value . . . . . . . . . . . . . . . . . . . . . . . . .

$4,362,779
225,762

$3,954,019
291,834

December 31,
2004

December 31,
2003

Other mortgage-backed securities pledged to counterparties at fair value . . . . . . . . . .
Residential real estate loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Allowance for loan losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Restricted cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interest and dividends receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Derivative instruments at fair value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Prepaid expenses and other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

4,588,541
63,470
2,628,334
(591)
3,042
1,250
28,141
6,399
484

4,245,853
—
—
—
196
—
17,007
—
218

$7,319,070

$4,263,274

LIABILITIES AND STOCKHOLDERS’ EQUITY

Liabilities:

Accrued interest payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Repurchase agreements (Anworth Mortgage) . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Repurchase agreements (Belvedere Trust)
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Whole loan financing facilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Mortgage-backed securities issued . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Derivative instruments at fair value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Dividends payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accrued expenses and other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

23,244
4,172,930
544,506
556,233
1,494,851
2,278
12,924
4,837

14,684
3,775,691
—
—
—
—
14,093
1,409

Minority interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Stockholders’ equity:

Series A cumulative preferred stock, par value $.01 per share, liquidation

preference $25.00 per share; authorized 20,000 shares; 1,101 shares issued
and outstanding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Common stock; par value $.01 per share; authorized 100,000 shares; 46,497 and
42,707 issued and outstanding, respectively . . . . . . . . . . . . . . . . . . . . . . . . . . .
Additional paid-in capital
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accumulated other comprehensive loss consisting of unrealized losses . . . . . . . . . . . .
Accumulated deficit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Unearned restricted stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$6,811,803

$3,805,877

231

—

465
560,745
(42,598)
(10,991)
(596)

427
488,909
(21,933)
(9,331)
(675)

507,036

457,397

$7,319,070

$4,263,274

See accompanying notes to consolidated financial statements.

F-4

ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except per share amounts)

Interest income net of amortization of premium and

discount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 163,023
(97,949)

$100,077
(45,661)

$ 66,855
(29,576)

For the Year Ended
December 31, 2004

For the Year Ended
December 31, 2003

For the Year Ended
December 31, 2002

Net interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . .

65,074

Gain on sale of securities . . . . . . . . . . . . . . . . . . . . . . .

Net gain on derivative instruments . . . . . . . . . . . . . . . .
Expenses:

External management fee . . . . . . . . . . . . . . . . . . .
External incentive fee . . . . . . . . . . . . . . . . . . . . . .
Compensation and benefits . . . . . . . . . . . . . . . . . .
Incentive compensation . . . . . . . . . . . . . . . . . . . . .
Provision for loan losses . . . . . . . . . . . . . . . . . . . .
Cost to acquire external manager . . . . . . . . . . . . .
Other expense . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Income from operations before minority interest . . . . .
Minority interest in net income of a subsidiary . . . . . . .

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Dividend on preferred stock . . . . . . . . . . . . . . . . . . . . .

Net income available to common stockholders . . . . . . .

Basic earnings per share available to common

stockholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Average number of shares outstanding . . . . . . . . . . . . .

Diluted earnings per share available to common

stockholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Average number of diluted shares outstanding . . . . . . .

259

340

—
—
(2,262)
(2,956)
(591)
—
(3,766)

(9,575)

56,098
(293)

55,805
(369)

55,436

1.23

45,244

1.22

45,329

$
$

Dividends declared per preferred share . . . . . . . . . . . . .

$0.335417

Dividends declared per common share . . . . . . . . . . . . .

1.25

54,416

3,497

—

—
—
(1,476)
(3,899)
—
—
(2,343)

(7,718)

50,195
—

$ 50,195
$ —

$ 50,195

1.52

32,927

1.52

33,112

$ —

1.56

37,279

4,709

—

(400)
(1,741)
(551)
(3,055)
—
(3,475)
(1,096)

(10,318)

31,670
—

$ 31,670
$ —

$ 31,670

1.81

17,461

1.80

17,591

$ —

2.00

See accompanying notes to consolidated financial statements.

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B

ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)

Operating Activities:

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Adjustments to reconcile net income to net cash provided by operating

55,805

50,195

31,670

For the year ended
December 31, 2004

For the year ended
December 31, 2003

For the year ended
December 31, 2002

activities:

Amortization of premiums and discounts (Anworth Mortgage) . . . . . . . . .
Amortization of premiums and discounts (Belvedere Trust) . . . . . . . . . . .
Gain on sale of agency securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Gain on sale of securities in securitization . . . . . . . . . . . . . . . . . . . . . . . . .
Gain on hedging instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Provision for loan losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Adjustment for minority interest in net income . . . . . . . . . . . . . . . . . . . . .
Amortization of restricted stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Changes in assets and liabilities:

Non-cash portion of costs incurred in acquiring external manager
. . . . . .
Increase in interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
(Increase) decrease in prepaid expenses and other . . . . . . . . . . . . . . . . . . .
Decrease (increase) in restricted cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Increase in accrued interest payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . .
Decrease (increase) in accrued expenses and other

47,619
3,784
(102)
(157)
(340)
591
293
79

—
(11,135)
(266)
(1,250)
8,560
3,428

Net cash provided by operating activities . . . . . . . . . . . . . . . . . . . . . .

106,909

Investing Activities:

Available-for-sale agency securities:

38,934
—
(3,497)
—
—
—
—
79

—
(5,334)
984
—
4,740
(467)

85,634

14,248
—
(4,709)
—
—
—
—
40

3,180
(9,380)
(1,192)
—
8,651
1,011

43,519

Purchases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Proceeds from sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Principal payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

(2,281,202)
119,356
1,748,572

(3,560,512)
174,879
1,497,654

(2,855,365)
272,512
538,563

Available-for-sale other mortgage-backed securities:

(18,546)
—
14,367

Residential real estate loans:

Purchases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Proceeds from sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

(3,030,405)
196,428

ARM loans collateralizing mortgage-backed securities issued:

Principal payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

141,350

—
—
—

—
—

—

—
—
—

—
—

—

Net cash used in investing activities . . . . . . . . . . . . . . . . . . . . . . . . . .

(3,110,080)

(1,887,979)

(2,044,290)

Financing Activities:

Net borrowings from repurchase agreements . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net whole loan financing facilities borrowings . . . . . . . . . . . . . . . . . . . . . . . . .
Borrowings on mortgage-backed securities issued . . . . . . . . . . . . . . . . . . . . . . .
Repayments on mortgage-backed securities issued . . . . . . . . . . . . . . . . . . . . . .
Proceeds from preferred stock issued, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Proceeds from common stock issued, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Minority investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Common stock dividends paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Minority profit distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

941,745
556,233
1,577,376
(82,525)
26,435
45,449
50
(58,635)
(111)

Net cash provided by financing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

3,006,017

Net increase (decrease) in cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . .
Cash and cash equivalents at beginning of period . . . . . . . . . . . . . . . . . . . . . . . . . . .

Cash and cash equivalents at end of period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Supplemental Disclosure of Cash Flow Information:

Cash paid for interest

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Supplemental Disclosure of Investing and Financing Activities:

Certificates retained from securitization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Common stock issued in connection with acquisition of external manager . . . .
Restricted stock issued . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Retirement of treasury stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$
$

2,846
196

3,042

89,389

64,451
—
—
—

1,621,821
—
—
—
—
232,575
—
(52,761)
—

1,801,635

(710)
906

196

40,921

—
—
—
229

$
$

1,828,563
—
—
—
—
198,495
—
(25,671)
—

2,001,387

$
$

616
290

906

20,925

—
3,180
794
—

See accompanying notes to consolidated financial statements.

F-7

ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (in thousands)

For the Year Ended
December 31,

2004

2003

2002

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . .
Available-for-sale agency securities, fair value adjustment
Other mortgage-backed securities, fair value adjustment . . . . . . . . . . . . . . .
Unrealized losses on cash flow hedges . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Reclassification adjustment for interest expense included in net income . . .

$ 55,805
(23,558)
(1,229)
(128)
4,250

$ 50,195
(36,793)
—
—
—

$31,670
14,155
—
—
—

Comprehensive income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

(20,665)
$ 35,140

(36,793)
$ 13,402

14,155
$45,825

See accompanying notes to consolidated financial statements.

F-8

ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES

Anworth Mortgage Asset Corporation was incorporated in Maryland on October 20, 1997. We commenced
our operations of purchasing and managing an investment portfolio of primarily adjustable-rate mortgage-backed
securities on March 17, 1998, upon completion of the initial public offering of our common stock. We seek
attractive long-term investment returns primarily by investing our equity capital and borrowed funds in
mortgage-backed securities. Our returns are principally earned on the spread between the yield on our interest-
earning assets and the interest cost of the funds we borrow.

On November 3, 2003, we formed a wholly-owned subsidiary called Belvedere Trust Mortgage

Corporation, or Belvedere Trust. Belvedere Trust was formed to acquire, own and securitize mortgage loans,
with a focus on the high credit-quality jumbo adjustable-rate, hybrid and second-lien mortgage markets.
Belvedere Trust acquires mortgage loans, securitizes a substantial amount of those mortgage loans and then
retains a portion of those mortgage-backed securities, while pledging the balance to third parties in the secondary
market. The mortgage-backed securities that are retained are purchased by a qualified REIT subsidiary to
maximize tax efficiency on the interest income on those securities. Belvedere Trust was formed as a qualified
REIT subsidiary, but it structures securitizations through taxable REIT subsidiaries (which generally are taxed as
C corporations subject to full corporate taxation), which in turn establish special purpose entities that issue
securities through real estate mortgage investment conduit, or REMIC, trusts. Since its formation, Belvedere
Trust has become an increasingly important part of our overall operations and, as of December 31, 2004,
Belvedere Trust’s assets comprised 37% of our overall assets. Through December 31, 2004, we had made an
investment of approximately $96 million in Belvedere Trust to capitalize its mortgage operations.

Belvedere Trust is externally managed by BT Management Company, L.L.C., or BT Management, a
Delaware limited liability company that is owned 50% by us and 50% by the executive officers of Belvedere
Trust. BT Management manages Belvedere Trust through a management agreement with Belvedere Trust
pursuant to which BT Management manages the day-to-day operations of Belvedere Trust in exchange for an
annual base management fee and a quarterly incentive fee.

In January 2003, the Financial Accounting Standards Board, or FASB, issued FASB Interpretation No. 46,

Belvedere Trust structures securitization transactions primarily through non-qualified special purpose

entities (such as REMIC trusts). The principal business activity involves issuing various series of mortgage-
backed securities (in the form of pass-through certificates or bonds collateralized by residential real estate loans).
The collateral specific to each series of mortgage-backed securities is the sole source of repayment of the debt
and, therefore, our exposure to loss is limited to our net investment in the collateral. Under FIN 46, these
interests in non-qualified special purpose entities are deemed to be VIEs and we are considered the primary
beneficiary. We disclose our interests in VIEs under FIN 46 in the Investments in Residential Real Estate Loans
footnote.

BASIS OF PRESENTATION AND CONSOLIDATION

The accompanying consolidated financial statements are prepared on the accrual basis of accounting in

accordance with generally accepted accounting principles, or GAAP, utilized in the United States. The

F-9

ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

preparation of financial statements in conformity with GAAP 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 materially differ from those estimates. Our consolidated financial
statements include the accounts of all subsidiaries. Significant intercompany accounts and transactions have been
eliminated.

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

Cash and Cash Equivalents

Cash and cash equivalents include cash on hand and highly liquid investments with original maturities of

three months or less. The carrying amount of cash equivalents approximates their fair value.

Restricted Cash

Restricted cash may include principal and interest payments on real estate loans or securities held as
collateral for mortgage-backed securities issued, cash pledged as collateral on certain interest rate agreements
and cash held from borrowers until certain loan agreement requirements have been met. Any corresponding
liability for cash held from borrowers is included in under “Accrued Expenses and Other” liabilities on our
consolidated balance sheets.

Mortgage-Backed Securities (MBS)

Relative to our investment grade agency MBS portfolio, we have invested primarily in fixed-rate and
adjustable-rate mortgage-backed pass-through certificates and hybrid adjustable-rate mortgage-backed securities.
Hybrid adjustable-rate mortgage-backed securities have an initial interest rate that is fixed for a certain period,
usually three to five years, and then adjust annually for the remainder of the term of the loan. We structure our
investment portfolio to be diversified with a variety of prepayment characteristics, investing in mortgage-related
assets with prepayment penalties, investing in certain mortgage security structures that have prepayment
protections, and purchasing mortgage related assets at a premium and at a discount.

Other mortgage-backed securities at fair value include securities which are backed by first-lien hybrid
adjustable-rate residential mortgages. These mortgage-backed securities include investment grade and non-
investment grade securities with a carrying value of approximately $63.5 million. This amount consists of
approximately $45 million in securities that were retained from our first securitization during the first quarter of
2004. The remaining balance of approximately $18 million were securities that were purchased from major
issuers.

The non-investment grade securities include first loss, second loss and third loss securities. Credit losses are

generally allocated to securities in order, beginning with the first loss security up to a maximum of the principal
amount of the first loss security. Losses are then allocated in order to the second loss, third loss and more senior
securities. Since these securities include the first loss security, we bear credit risk associated with mortgages with
a face value of $179 million (see Note 3).

We also bear the credit risk related to our residential real estate loans as discussed under Note 1 in the
section titled “Credit Risk.” As of December 31, 2004, we have not sold the subordinate securities from our
securitizations to third parties.

F-10

ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

We classify our investments as either trading investments, available-for-sale investments or held-to-maturity
investments. Management determines the appropriate classification of the securities at the time they are acquired
and evaluates the appropriateness of such classifications at each balance sheet date. We currently classify all of
our agency and non-agency securities as available-for-sale. All assets that are classified as available-for-sale are
carried at fair value and unrealized gains or losses are included in other comprehensive income or loss as a
component of stockholders’ equity. Losses on securities classified as available-for-sale which are determined by
management to be other than temporary in nature are reclassified from accumulated other comprehensive income
to current operations.

Interest income on our mortgage-backed securities is accrued based on the actual coupon rate and the
outstanding principal amount of the underlying mortgages. Premiums and discounts are amortized or accreted
into interest income over the lives of the securities using the effective interest yield method adjusted for the
effects of estimated prepayments based on the Statement of Financial Accounting Standards, or SFAS, No. 91,
“Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial
Direct Costs of Leases,” an amendment of FASB Statements No. 13, 60, and 65 and a rescission of FASB
Statement No. 17. Our policy for estimating prepayments speeds for calculating the effective yield is to evaluate
historical performance, street consensus prepayment speeds and current market conditions. If our estimate of
prepayments is incorrect, we may be required to make an adjustment to the amortization or accretion of
premiums and discounts that would have an impact on future income.

Securities are recorded on the date the securities are purchased or sold (the trade date). Realized gains or

losses from securities transactions are determined based on the specific identified cost of the securities.

The following table shows our investments’ gross unrealized losses and fair value of those individual

securities that have been in a continuous unrealized loss position, at December 31, 2004, aggregated by
investment category and length of time:

Description of Securities

Federal agency mortgage-backed

Less than 12 months

12 months or more

Total

Fair
Value

Unrealized
Losses

Fair
Value

Unrealized
Losses

Fair
Value

Unrealized
Losses

(in thousands)

securities . . . . . . . . . . . . . . . . . . . .
Other mortgage-backed securities . .

$2,727,897
58,163
$

(24,068) $1,390,293
—

(1,302) $

(23,290) $4,118,190
58,163

— $

(47,358)
(1,302)

We do not consider those securities that have been in a continuous loss position for 12 months or more to be
other than temporarily impaired due to the fact that these are government-sponsored agency guaranteed securities
with limited credit risk and the Company has the ability and intent to hold these investments until a forecasted
recovery of fair value up to the cost of the investment which, in certain cases, may mean until maturity.

Residential Real Estate Loans

We acquire residential mortgage loans and hold them as long-term investments through our Belvedere Trust
subsidiary. We finance the mortgage loans with short-term debt until a sufficient quantity has been accumulated
for securitization into mortgage-backed securities in order to obtain long-term financing and to enhance liquidity.
While all mortgage loans are acquired with the intention of securitizing them, we may not be successful in our
efforts to securitize the loans into mortgage-backed securities. Our residential real estate loans are classified as
held-for-investment and are carried at their unpaid principal balance adjusted for unamortized premiums or
discounts. Premiums or discounts are amortized into current operations.

F-11

ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

To meet our investment criteria, mortgage loans acquired by us will generally conform to the underwriting

guidelines established by the Federal Home Loan Mortgage Corporation, or Freddie Mac, Fannie Mae and the
Government National Mortgage Association, or Ginnie Mae, or to secondary market standards for “A” quality
mortgage loans. Applicable banking laws generally require that an appraisal be obtained in connection with the
original issuance of mortgage loans by the lending institution, and we do not intend to obtain additional
appraisals at the time of acquiring mortgage loans. Mortgage loans may be originated by or purchased from
various suppliers of mortgage-related assets throughout the United States, including savings and loans
associations, banks, mortgage bankers and other mortgage lenders. We may acquire mortgage loans directly from
originators and from entities holding mortgage loans originated by others.

Our Belvedere Trust subsidiary maintains an allowance for loan losses for residential real estate loans held

in consolidated securitization trusts and for loans held prior to securitization. The balance is included in
“Allowance for Loan Losses” on the consolidated balance sheets.

Allowance for Loan Losses

Repurchase Agreements

We finance the acquisition of our MBS through the use of repurchase agreements. Under these repurchase
agreements, we sell securities to a lender and agree to repurchase the same securities in the future for a price that is
higher than the original sales price. The difference between the sale price that we receive and the repurchase price
that we pay represents interest paid to the lender. Although structured as a sale and repurchase obligation, a
repurchase agreement operates as a financing under which we pledge our securities as collateral to secure a loan
which is equal in value to a specified percentage of the estimated fair value of the pledged collateral. We retain
beneficial ownership of the pledged collateral. At the maturity of a repurchase agreement, we are required to repay
the loan and concurrently receive back our pledged collateral from the lender or, with the consent of the lender, we
may renew such agreement at the then prevailing financing rate. These repurchase agreements may require us to
pledge additional assets to the lender in the event the estimated fair value of the existing pledged collateral declines.

Derivative Financial Instruments

Interest Rate Risk Management

We use primarily short-term (less than or equal to 12 months) repurchase agreements to finance the
purchase of our MBS. These obligations expose us to variability in interest payments due to changes in interest
rates. We continuously monitor changes in interest rate exposures and evaluate hedging opportunities.

Our objective is to limit the impact of interest rate changes on earnings and cash flows. We achieve this by
entering into interest rate swap agreements to convert a percentage of our Repurchase Agreements to fixed rate
obligations over a period up to five years. Under interest rate swap contracts, we agree to pay an amount equal to

F-12

ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

a specified fixed-rate of interest times a notional principal amount, and to receive in return an amount equal to a
specified variable-rate of interest times a notional amount, generally based on LIBOR. The notional amounts are
not exchanged. We account for these swap agreements as cash flow hedges. We do not issue or hold derivative
contracts for speculative purposes.

We are exposed to credit losses in the event of non-performance by counterparties to these interest rate swap
agreements, but we do not expect any of the counterparties to fail to meet their obligations. In order to limit credit
risk associated with swap agreements, our current policy is to only purchase swap agreements from financial
institution counterparties rated “A” or better by at least one of the rating agencies, limit our exposure to a single
counterparty under our defined guidelines and either pay or receive collateral to or from each counterparty on a
periodic basis to cover the net fair market value position of the swap agreements held with that counterparty.

Belvedere Trust uses Eurodollar futures in order to mitigate the impact of rising interest rates on planned

securitization funding. There is usually a time difference between the date we enter into an agreement to
purchase whole loans and the date on which we fix the interest rates paid for securitization financing. We are
exposed to interest rate fluctuations during this period.

Accounting for Derivatives and Hedging Activities

In accordance with FASB No. 133, “Accounting for Derivative Instruments and Hedging Activities”, or FASB

133, as amended by FASB No. 138, “Accounting for Certain Derivative Instruments and Certain Hedging
Activities”, or FASB 138, a derivative that is designated as a hedge is recognized as an asset/liability and measured
at estimated fair value. In order for our interest rate swap agreements to qualify for hedge accounting, upon entering
into the swap agreement, we must anticipate that the hedge will be highly “effective,” as defined by FASB 133.

On the date we enter into a derivative contract, we designate the derivative as a hedge of the variability of cash

flows that are to be received or paid in connection with a recognized asset or liability (a “cash flow” hedge).
Changes in the fair value of a derivative that is highly effective and that is designated and qualifies as a cash flow
hedge, to the extent that the hedge is effective, are recorded in Other Comprehensive Income, and reclassified to
earnings when the derivative is affected by the variability of cash flows of the hedged transaction (e.g., when
periodic settlement interest payments are due on repurchase agreements). The swap agreements are carried on our
consolidated balance sheets at their fair value. Hedge ineffectiveness, if any, is recorded in current-period earnings.

We formally document all relationships between hedging instruments and hedged items, as well as our risk-
management objective and strategy for undertaking various hedge transactions. This process includes linking all
derivatives that are designated as cash flow hedges to (1) specific assets and liabilities on the balance sheet or (2)
specific firm commitments or forecasted transactions. We also formally assess (both at the hedge’s inception and
on an ongoing basis) whether the derivatives that are used in hedging transactions have been highly effective in
offsetting changes in the cash flows of hedged items and whether those derivatives may be expected to remain
highly effective in the future periods. If it is determined that a derivative is not (or has ceased to be) highly
effective as a hedge, we discontinue hedge accounting prospectively, as discussed below.

We discontinue hedge accounting prospectively when (1) we determine that the derivative is no longer

effective in offsetting changes in the cash flows of a hedged item (including hedged items such as firm
commitments or forecasted transactions); (2) the derivative expires or is sold, terminated, or exercised; (3) it is
no longer probable that the forecasted transaction will occur; (4) a hedged firm commitment no longer meets the
definition of a firm commitment; or (5) management determines that designating the derivative as a hedging
instrument is no longer appropriate.

F-13

ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

When we discontinue hedge accounting because it is no longer probable that the forecasted transaction will

occur in the originally expected period, the gain or loss on the derivative remains in accumulated other
comprehensive income and is reclassified into earnings when the forecasted transaction affects earnings.
However, if it is probable that a forecasted transaction will not occur by the end of the originally specified time
period or within an additional two-month period of time thereafter, the gains and losses that were accumulated in
other comprehensive income will be recognized immediately in earnings. In all situations in which hedge
accounting is discontinued and the derivative remains outstanding, we will carry the derivative at its fair value on
the balance sheet, recognizing changes in the fair value in current-period earnings.

For purposes of the cash flow statement, cash flows from derivative instruments are classified with the cash

flows from the hedged item.

In connection with its loan acquisitions, Belvedere Trust enters into forward loan purchase commitments.
Belvedere Trust uses Eurodollar futures to mitigate the impact of rising interest rates on planned securitization
funding. Both of these are treated as derivatives, carried at fair value and any changes in fair value are recognized
in current-period earnings.

Credit Risk

At December 31, 2004, we had limited our exposure to credit losses on our portfolio of fixed-rate and
adjustable-rate mortgage-backed securities by purchasing primarily securities from Freddie Mac and Fannie Mae.
The payment of principal and interest on the Freddie Mac and Fannie Mae mortgage-backed securities are
guaranteed by those respective agencies. At December 31, 2004, because of the guarantee of these government-
sponsored agencies, all of our agency mortgage-backed securities have an implied “AAA” rating.

Other-than-temporary losses on available-for-sale investment securities, as measured by the amount of
decline in estimated fair value attributable to factors that are considered to be other-than-temporary, are charged
against income, resulting in an adjustment of the cost basis of such securities. The following are among, but not
all of, the factors considered in determining whether and to what extent an other-than-temporary impairment
exists: (i) the expected cash flow from the investment; (ii) whether there has been an other-than-temporary
deterioration of the credit quality of the underlying mortgages; (iii) the credit protection available to the related
mortgage pool for MBS; (iv) any other market information available, including analysts assessments and
statements, public statements and filings made by the debtor, or counterparty; (v) management’s internal analysis
of the security, considering all known relevant information at the time of assessment; and (vi) the magnitude and
duration of historical decline in market prices. Because management’s assessments are based on factual
information as well as subjective information available at the time of assessment, the determination as to whether
an other-than-temporary decline exists and, if so, the amount considered impaired is also subjective and,
therefore, constitutes material estimates that are susceptible to a significant change. At December 31, 2004, we
had no assets on which an impairment charge had been taken.

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

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

F-14

ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

the loss equal to the difference between the realizable value of the mortgaged property, after expenses, and the
outstanding indebtedness, as well as the loss of interest.

We establish and maintain an allowance for estimated loan losses on our residential real estate loans. The

allowance for loan losses is based upon estimates of inherent losses on the portfolio of residential loans. Various
factors, including borrowers’ credit scores and loan-to-value ratios, are used to estimate losses. A provision for
loan losses is recognized through our consolidated statements of income.

Income Taxes

We have elected to be taxed as a REIT and to comply with the provisions of the Internal Revenue Code of
1986, as amended, or the Code, with respect thereto. Accordingly, we will not be subject to Federal income tax to
the extent that our distributions to stockholders satisfy the REIT requirements and certain asset, income and stock
ownership tests are met.

Belvedere Trust Finance Corporation, or BT Finance, an indirect wholly-owned subsidiary of the Company,

and BT Finance’s wholly-owned subsidiaries, BT Residential Funding Corporation and BellaVista Funding
Corporation, are taxable REIT subsidiaries (TRS) of the Company. In general, a TRS of the Company may hold
assets that the Company cannot hold directly and may engage in any real estate or non-real estate related
business. A TRS is subject to corporate federal and state income tax and will be taxed as a regular C corporation.
Securities of a TRS will constitute non-real estate assets for purposes of determining whether at least 75% of a
REIT’s assets consist of real estate. Under current law, no more than 20% of a REIT’s total assets can consist of
securities of one or more taxable REIT subsidiaries. As of December 31, 2004, the amount of the Company’s
assets attributable to its taxable REIT subsidiaries was less than 10%. At December 31, 2004, BT Finance and
subsidiaries had approximately $3 million of federal net operating losses, resulting in an immaterial deferred tax
asset that is fully reserved. A more detailed description of federal income tax considerations regarding the
Company’s qualifications and taxation as a REIT appears on page 11.

Stock-Based Compensation

SFAS 123, “Accounting for Stock-Based Compensation,” amended by SFAS 148, “Accounting for Stock-
Based Compensation—Transition and Disclosure,” encourages companies to measure compensation cost of stock-
based awards based on their estimated fair value at the date of grant and recognize that amount over the related
service period. We believe the existing stock option valuation models do not necessarily provide a transparent
measure of the fair value of stock-based awards. Therefore, as permitted by SFAS 148, we apply the existing
accounting rules under APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and related
Interpretations. In general, as the exercise price of all options granted under these plans is equal to the market price
of the underlying common stock on the grant date, no stock-based employee compensation cost is recognized in net
income. In addition, under these plans, options to purchase shares of common stock may be granted at less than fair
market value, which results in compensation expense equal to the difference between the market value on the date
of grant and the purchase price. This expense is recognized over the vesting period of the shares in net income.

On December 16, 2004, the FASB issued the final statement on “Accounting for Share-Based Payments”
(FASB 123(R)) which is effective for certain public entities as of the first interim reporting period that begins
after June 15, 2005. This statement replaces FASB 123, “Accounting for Stock Based Compensation” and
supersedes APB Opinion 25, “Accounting for Stock Issued to Employees”. Instead of disclosing the effect of
stock options in a footnote to the financial statements, this statement will require that compensation cost relating
to share-based payment transactions be recognized in the financial statements and that cost will be measured on
the fair value of the equity or liability instruments issued. The provisions of FASB 123(R) are not expected to

F-15

ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

have a material effect on the Company’s financial statements. Prior to the effective date of FASB 123(R), the
Company has elected to continue to provide the disclosures set forth in SFAS 123, as amended by FASB 148.

As required by SFAS 123, as amended by SFAS 148, we provide pro forma net income and pro forma net

income per common share disclosures for stock-based awards as if the fair-value-based method defined in SFAS
123 had been applied. Had we determined compensation cost based on the fair value at the grant date for our
stock options under FASB No. 123, our net income would have been reduced to the pro forma amounts indicated
below for fiscal years ended December 31:

(in thousands, except per share amounts)

Net income available to common stockholders, as reported . . . . . . . . . .
Add: Stock-based compensation expense included in Net Income . . . . .
Less: Total stock-based compensation expense determined under the

2004

2003

2002

$55,436
79

$50,195
79

$31,670
40

fair value-based method for all awards, net of related taxes . . . . . . . .

235

276

Pro forma net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Basic income per share, as reported . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Pro forma basic income per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Diluted income per share, as reported . . . . . . . . . . . . . . . . . . . . . . . . . . .
Pro forma diluted income per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$55,280
1.23
$
1.22
$
1.22
$
1.22
$

$49,998
1.52
$
1.52
$
1.52
$
1.51
$

$31,642
1.81
$
1.81
$
1.80
$
1.80
$

The fair value of the aforementioned stock-based awards was estimated using the Black-Scholes model with

the following weighted-average assumptions for fiscal years ended December 31:

Assumptions:

Dividend yield . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Expected volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Risk-free interest rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Expected lives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

10.00% 11.00% 17.00%
32.00% 32.00% 27.00%
4.30%
3.52%
2.97%

6.4 years

8.4 years

8.8 years

2004

2003

2002

Earnings Per Share

Basic earnings per share, or EPS, is computed by dividing net income available to common stockholders by

the weighted average number of common shares outstanding during the period. Diluted EPS assumes the
conversion, exercise or issuance of all potential common stock equivalents unless the effect is to reduce a loss or
increase the income per share.

F-16

ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

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

Income
Available to
Common
Stockholders

Average
Shares

Earnings
Per
Share

For the year ended December 31, 2004
Basic EPS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Effect of dilutive securities: Stock options . . . . . . . . . . . . . . . . . . . . . .

$55,436
—

45,244
85

$ 1.23
(0.01)

Diluted EPS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$55,436

45,329

$ 1.22

For the year ended December 31, 2003
Basic EPS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Effect of dilutive securities: Stock options . . . . . . . . . . . . . . . . . . . . . .

$50,195
—

32,927
185

$ 1.52
—

Diluted EPS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$50,195

33,112

$ 1.52

For the year ended December 31, 2002
Basic EPS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Effect of dilutive securities: Stock options . . . . . . . . . . . . . . . . . . . . . .

$31,670
—

17,461
130

$ 1.81
(0.01)

Diluted EPS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$31,670

17,591

$ 1.80

Accumulated Other Comprehensive Income (Loss)

The Financial Accounting Standard Board’s Statement 130, “Reporting Comprehensive Income,” divides

comprehensive income into net income and other comprehensive income (loss), which includes unrealized gains
and losses on marketable securities defined as available-for-sale and unrealized gains and losses on derivative
financial instruments that qualify for hedge accounting under FASB 133.

USE OF ESTIMATES

The preparation of financial statements in conformity with generally accepted accounting principles in the

United States of America requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the reporting period. Actual results could
materially differ from those estimates.

RECENT ACCOUNTING PRONOUNCEMENTS

In March 2004, the Emerging Issues Task Force (EITF) of the Financial Accounting Standards Board
reached a consensus on Issue 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to
Certain Investments”. This EITF applies to all debt and equity securities currently accounted for under FASB
115, “Accounting for Certain Investments in Debt and Equity Securities”. EITF 03-1 requires evaluation of
whether impairment is other than temporary. An impairment loss is equal to the difference between the
investment’s cost and fair value. An impairment is considered other than temporary if the investor does not have
the ability and intent to hold for a reasonable period of time sufficient for recovery of fair value and if it is
probable that the investor will be unable to collect all contractual amounts due or if the impairment is considered
other than a minor impairment. A minor impairment is considered 5% or less of value. For ordinary debt
securities with no credit problems where the decrease in fair value is caused solely by rising interest rates, an
impairment is deemed other than temporary unless the investor has the ability and intent to hold for a reasonable

F-17

ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

period of time sufficient for recovery of fair value or if it is considered a minor impairment. The Company does
not believe this EITF will have a material impact on its financial statements as the Company has reviewed its
securities portfolio and does not consider those securities that have been in a continuous loss position for 12
months or more to be other than temporarily impaired due to the fact that they are government-sponsored agency
securities with limited credit risk and the Company has the ability and intent to hold these securities until a
forecasted recovery, which may mean until maturity. The FASB suspended the effective date of the consensus,
other than disclosure requirements.

On December 16, 2004, the FASB issued the final statement on “Accounting for Share-Based Payments”
(FASB 123(R)) which is effective for all public entities as of the first interim reporting period that begins after
June 15, 2005. This statement covers a wide range of share-based compensation arrangements including share
options, restricted share plans, performance-based awards, share appreciation rights and employee share purchase
plans. This statement replaces FASB 123, “Accounting for Stock Based Compensation” and supersedes APB
Opinion 25, “Accounting for Stock Issued to Employees”. Instead of disclosing the effect of stock options in a
footnote to the financial statements, this statement will require that compensation cost relating to share-based
payment transactions be recognized in the financial statements and that cost will be measured on the fair value of
the equity or liability instruments issued. The provisions of FASB 123 (R) are not expected to have a material
effect on the Company’s financial statements.

NOTE 2. SECURITIES

The following table summarizes our mortgage-backed securities classified as available-for-sale as of

December 31, 2004 and 2003, which are carried at their fair value (amounts in thousands):

December 31, 2004

Ginnie Mae

Freddie Mac

Fannie Mae

Total
Agency MBS
Assets

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Amortized cost
Paydowns receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Unrealized gains . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Unrealized losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$131,686
—
—
(2,461)

$1,141,429
26,335
228
(10,082)

$3,334,582
—
1,639
(34,815)

$4,607,697
26,335
1,867
(47,358)

Fair value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$129,225

$1,157,910

$3,301,406

$4,588,541

Amortized cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Unrealized losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Unrealized gains . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$64,699
(1,302)
73

Fair value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$63,470

Other
MBS

F-18

ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

December 31, 2003

Ginnie Mae

Freddie Mac

Fannie Mae

Total
Agency MBS
Assets

$203,336
—
—
(1,941)

$1,046,725
16,894
1,204
(5,306)

$3,000,831
—
4,562
(20,452)

$4,250,892
16,894
5,766
(27,699)

Fair value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$201,395

$1,059,517

$2,984,941

$4,245,853

The following table summarizes our agency securities at their fair value as of December 31, 2004 and 2003

(amounts in thousands):

December 31, 2004

ARMs

Hybrids

Fixed

Floating-
Rate CMO

Total

Amortized cost
. . . . . . . . . . . . . . . . . . . . . . . . . .
Paydowns receivable . . . . . . . . . . . . . . . . . . . . . .
Unrealized gains . . . . . . . . . . . . . . . . . . . . . . . . .
Unrealized losses . . . . . . . . . . . . . . . . . . . . . . . . .

$1,427,620
8,929
896
(14,278)

$2,955,923
17,406
504
(28,453)

$205,717
—
425
(4,627)

$18,437
—
42
—

$4,607,697
26,335
1,867
(47,358)

Fair value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$1,423,167

$2,945,380

$201,515

$18,479

$4,588,541

December 31, 2003

. . . . . . . . . . . . . . . . . . . . . . . . . .
Amortized cost
Paydowns receivable . . . . . . . . . . . . . . . . . . . . . .
Unrealized gains . . . . . . . . . . . . . . . . . . . . . . . . .
Unrealized losses . . . . . . . . . . . . . . . . . . . . . . . . .

$1,133,587
5,539
1,490
(4,903)

$2,682,363
11,355
2,024
(17,416)

$404,677
—
2,240
(5,181)

ARMs

Hybrids

Fixed

Floating-
Rate CMO

$30,265
—
12
(199)

Total

$4,250,892
16,894
5,766
(27,699)

Fair value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$1,135,713

$2,678,326

$401,736

$30,078

$4,245,853

NOTE 3. SECURITIZATION ACTIVITIES

Five of the six securitization transactions in the year ended December 31, 2004 utilized non-qualified SPEs

requiring consolidation, which effectively resulted in the transactions being accounted for as financings. The
residential real estate loans remain as assets on our balance sheet subsequent to securitization, and the financing
resulting from these securitizations is shown on our consolidated balance sheets as “mortgage-backed securities
issued.”

We acquire residential mortgage loans from third party originators, including banks and other mortgage
lenders, through our Belvedere Trust subsidiary. During the three months ended December 31, 2004, Belvedere
Trust transferred approximately $1.1 billion of residential mortgage loans in two separate transactions to
securitization trusts pursuant to pooling and third party servicing agreements. During the three months ended
September 30, 2004, we transferred approximately $391 million of residential mortgage loans to a securitization

F-19

ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

trust pursuant to a pooling and third party servicing agreement dated as of July 1, 2004. During the three months
ended June 30, 2004, we transferred approximately $345 million of residential mortgage loans (of which $147
million were purchased during the second quarter of 2004) to a securitization trust pursuant to a pooling and third
party servicing agreement dated as of April 1, 2004, and we acquired approximately $314 million of residential
mortgage loans which were transferred to a securitization trust pursuant to a pooling and third party servicing
agreement dated as of May 1, 2004. The servicing of the mortgage loans is performed by third parties under
servicing arrangements that resulted in no servicing asset or liability.

During the three months ended March 31, 2004, we transferred approximately $253 million of residential

mortgage loans to a securitization trust pursuant to a pooling and third party servicing agreement dated as of
February 1, 2004. The transaction was accounted for as a sale. The net proceeds of the sale were used primarily
to pay off a warehouse line of credit. The retained securities are carried at amortized cost, adjusted for fair
market valuation based on quoted market prices. As these securities include first loss security, we bear the credit
risk associated with these mortgages. The principal balance outstanding, at December 31, 2004, of all the
securities from this transaction was $179 million; the amount derecognized was $134 million and the amount
recognized as our retained securities was $45 million. The delinquent amount of all the principal balances from
this transaction was $3 million and there have been no credit losses to date.

The information in the following table projects the impact of sudden changes in interest rates on the fair

value of these retained securities at December 31, 2004:

Change in Interest Rates

Projected Percentage Change
in Retained Securities

-2.0% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.3%
-1.0% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0.7%
0% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . —
1.0% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -2.0%
2.0% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -5.4%

At December 31, 2004, we had acquired approximately $578 million in residential mortgage loans

(including related premiums) which are scheduled to be securitized at a later date.

NOTE 4. RESIDENTIAL REAL ESTATE LOANS

Our residential real estate loan portfolio of $2.63 billion at December 31, 2004 includes $578 million of

loans pending securitization and $2.05 billion in loans which have been financed through securitization.

The following table represents the changes at December 31, 2004 in our residential real estate loans (in

thousands):

Balance, beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

—

New loan acquisitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Sales (other than to consolidated securitization trusts)(1)
. . . . . . . . . . . . . . . . . .
Principal repayments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Premium amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net recognized gains and valuation adjustments . . . . . . . . . . . . . . . . . . . . . . . . .

3,030,405
(258,164)
(141,350)
(3,079)
522

Balance, end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$2,628,334

(1)

Includes related premium

F-20

ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The following table represents the changes at December 31, 2004 in our residential allowance for loan

losses (in thousands):

Balance, beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Additions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$—
591

Balance, end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$591

NOTE 5. REPURCHASE AGREEMENTS

Agency Repurchase Agreements

We have entered into repurchase agreements to finance most of our MBS. The repurchase agreements are
short-term borrowings that are secured by the market value of our MBS and bear fixed interest rates that have
historically had their basis on LIBOR. Relative to our agency MBS portfolio, at December 31, 2004, our
repurchase agreements had a weighted average term to maturity of 184 days and a weighted average borrowing
rate of 2.25%. After adjusting for swap transactions, the weighted average term to the next rate adjustment was
304 days with a weighted average borrowing rate of 2.34%. At December 31, 2004, agency MBS with a fair
value of approximately $4.36 billion have been pledged as collateral under the repurchase agreements.

At December 31, 2004, the repurchase agreements had the following remaining maturities:

Less than 3 months . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3 months to less than 1 year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1 year to less than 2 years . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2 years to less than 3 years . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . —
Greater than 3 years . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . —

36.9%
51.9%
11.2%

100.0%

Belvedere Trust Repurchase Agreements

We have entered into repurchase agreements to finance most of our other MBS. In addition, we have entered

into repurchase agreements to finance most of the retained portion of the residential real estate loans which we
have securitized. The repurchase agreements are short-term borrowings that are secured by the market value of
the pledged assets and bear interest rates that have historically had their basis on LIBOR. At December 31, 2004,
our repurchase agreements had a weighted average term to maturity of 313 days and a weighted average
borrowing rate of 2.65%.

At December 31, 2004, the repurchase agreements had the following remaining maturities:

Less than 3 months . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3 months to less than 1 year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1 year to less than 2 years . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2 years to less than 3 years . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Greater than 3 years . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . —

47.5%
3.1%
44.5%
4.9%

100.0%

F-21

ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

NOTE 6. MORTGAGE-BACKED SECURITIES ISSUED AND WAREHOUSE LOANS

We finance our residential real estate loans using mortgage-backed securities issued (obligations due on

pass-through certificates or bonds) through securitizations. The interest rates on the mortgage-backed securities
issued are variable and are based either upon the interest rates on the underlying loan collateral or upon LIBOR.
The maturities on the mortgage-backed securities issued are also based upon the maturities of the underlying
mortgages. Principal is paid on the mortgage-backed securities issued following receipt of principal payments on
the loans. The scheduled maturities of the mortgage-backed securities issued extend to February 2035. At
December 31, 2004, whole loans with a face value of approximately $2 billion have been pledged as collateral
for the mortgage-backed securities issued.

We have entered into whole loan financing facilities to finance our residential loan acquisitions prior to
securitization. The whole loan financing facilities are short-term borrowings that are secured by the loans and
bear interest rates that have historically had their basis on LIBOR. At December 31, 2004, loans with a face value
of approximately $567 million have been pledged as collateral under these facilities.

The following table represents, at December 31, 2004, the principal payments of the mortgage-backed

securities issued and the warehouse loans for each of the succeeding five years:

2005

2006

2007

2008

2009

(in thousands)

Whole loan financing facilities . . . . . . . . . .
Mortgage-backed securities issued . . . . . . .

$556,233
373,523

$ — $ — $ — $ —
118,185
280,142

157,580

210,107

The warehouse loans are short-term credit facilities. The total balance owed on the warehouse loans, as of
December 31, 2004, is due in 2005. Principal is paid on the mortgage-backed securities issued following receipt
of principal payments on the loans. For the table above, the principal payments have been estimated based on
prepayment assumptions. The actual principal paid in each year will be dependent upon the principal received on
the underlying loans. The collateral specific to each mortgage-backed securities series is the sole source of
repayment of the debt.

NOTE 7. FAIR VALUES OF FINANCIAL INSTRUMENTS

Agency MBS and other MBS are reflected in the financial statements at estimated fair value. Management

bases its fair value estimates for agency MBS and other MBS primarily on third-party bid price indications
provided by dealers who make markets in these financial instruments when such indications are available.
However, the fair value reported reflects estimates and may not necessarily be indicative of the amounts we
could realize in a current market exchange.

Cash and cash equivalents, interest receivable, repurchase agreements and payables for securities purchased

are reflected in the financial statements at their costs, which approximates their fair value because of the nature
of these instruments.

The following table of the estimated fair value of financial instruments at December 31, 2004 is made by

using available market information, historical data, and appropriate valuation methodologies. However,
considerable judgment is required to interpret market and historical data to develop the estimates of fair value.
Accordingly, the estimates presented herein are not necessarily indicative of the amounts we could realize in a
current market exchange.

F-22

ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The use of different market assumptions and/or estimation methodologies may have a material effect on the

estimated fair value amounts.

December 31, 2004

(in thousands)

Carrying
Amount

Estimated
Fair Value

Residential real estate loans pending securitization . . . . . . . . . . . .
Residential real estate loans securitized . . . . . . . . . . . . . . . . . . . . .
Mortgage-backed securities issued . . . . . . . . . . . . . . . . . . . . . . . . .

$ 577,932
2,050,402
1,494,851

$ 578,189
2,039,828
1,493,213

These fair value estimates at December 31, 2004 are based on pertinent information available to
management as of the respective dates. Although management is not aware of any factors that would
significantly affect the estimated fair value amounts, such amounts have not been revalued for purposes of these
consolidated financial statements since those dates and, therefore, current estimates of fair value may differ
significantly from the amounts presented herein.

•

Residential real estate loans are carried on the consolidated balance sheets at historical cost, net of
amortization, as we hold these assets for investment. The fair value of the residential real estate loans is
calculated using assumptions based on historical experience, industry information and estimated rates
of future prepayments and credit losses. The estimates of fair value are inherently subjective in nature,
involve matters of uncertainty and judgment and do not necessarily indicate the amounts that could be
received in a current market exchange;

The estimated fair value of mortgage-backed securities issued (obligations due on pass-through
certificates) is based on dealers’ quotes.

NOTE 8. PUBLIC OFFERINGS AND CAPITAL STOCK

In February 2004, we filed with the SEC an amended and restated Dividend Reinvestment and Stock
Purchase Plan pursuant to a registration statement on Form S-3, primarily to increase the number of shares
authorized under our predecessor plan. The plan allows stockholders and non-stockholders to purchase shares of
our common stock and to reinvest dividends in additional shares of our common stock. During the year ended
December 31, 2004, we issued 3,430,598 shares of common stock under the plan, resulting in proceeds to us of
approximately $41.6 million.

In April 2004, we entered into a sales agreement with Cantor to sell up to 6.0 million shares of common
stock from time to time through a controlled equity offering program under which Cantor acts as sales agent.
Sales of the shares are made on the New York Stock Exchange by means of ordinary brokers’ transactions at
market prices and through privately negotiated transactions. Commencing September 15, 2004 through the year
ended December 31, 2004, we sold 292,500 shares under the controlled equity offering program which provided
net proceeds to us of approximately $3.2 million. Cantor received an aggregate of approximately $99,000, which
represents a commission of 3% on the gross sales price per share under the sales agreement through December
31, 2004. The sales agreement with Cantor has subsequently been amended to provide for the sale of up to 2.0
million shares of Series A Preferred Stock

In May 2004, we filed a shelf registration statement on Form S-3 with the Securities and Exchange
Commission for offering up to $300 million of our capital stock. The registration statement incorporated the
securities available under our prior shelf registration statement and was declared effective on May 25, 2004. As
of December 31, 2004, $269 million of our securities remained available for issuance under the registration
statement.

F-23

ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

During November 2004, we completed a public offering of 1.15 million shares of 8.625% Series A
Cumulative Preferred Stock and received net proceeds of $26.4 million. The shares were sold pursuant to our
shelf registration on Form S-3.

At December 31, 2004, our authorized capital included 20 million shares of $.01 par value preferred stock,

of which 1.15 million shares had been designated 8.625% Series A Cumulative Preferred Stock (liquidation
preference $25.00 per share). The remaining preferred stock may be issued in one or more classes or series, with
such distinctive designations, rights and preferences as determined by our board of directors.

During the year ended December 31, 2004, various officers and employees exercised stock options to

purchase approximately 68,000 shares, resulting in proceeds to us of approximately $0.6 million.

NOTE 9. TRANSACTIONS WITH AFFILIATES

Anworth 2002 Incentive Compensation Plan

Under our 2002 Incentive Compensation Plan, eligible employees have the opportunity to earn incentive

compensation for each fiscal quarter. The total aggregate amount of compensation that may be earned by all
employees equals a percentage of taxable net income, before incentive compensation, in excess of the amount
that would produce an annualized return on average net worth equal to the Ten-Year US Treasury Rate plus 1%,
or the Threshold Return.

The 2002 Incentive Compensation Plan contains a “high water mark” provision requiring that in any fiscal

quarter in which our taxable net income is an amount less than the amount necessary to earn the Threshold
Return, we will calculate negative incentive compensation for that fiscal quarter which will be carried forward
and will offset future incentive compensation earned under the plan, but only with respect to those participants
who were participants during the fiscal quarter(s) in which negative incentive compensation was generated.

The percentage of taxable net income in excess of the Threshold Return earned under the plan by all

employees is calculated based on our quarterly average net worth as defined in the Incentive Compensation Plan.
The percentage rate used in this calculation is based on a blended average of the following tiered percentage
rates:

•

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

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

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

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

The 2002 Incentive Compensation Plan requires that we pay all amounts earned thereunder each quarter

(subject to offset for accrued negative incentive compensation), and we will be required to pay a percentage of
such amounts to certain of our executives pursuant to the terms of their employment agreements. For the year
ended December 31, 2004, eligible employees under the 2002 Incentive Compensation Plan earned $2,723,000 in
incentive compensation.

Employment Agreements

Pursuant to the terms of employment agreements with us, Lloyd McAdams serves as our President,
Chairman and Chief Executive Officer, Joseph E. McAdams serves as our Chief Investment Officer and

F-24

ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Executive Vice President, and Heather U. Baines serves as our Executive Vice President. Pursuant to the terms of
an addendum to his original employment agreement, Lloyd McAdams receives a base salary of $600,000 per
annum. Pursuant to the terms of an addendum to his original employment agreement, Joseph McAdams receives
a base salary equal to $400,000 per annum. Heather U. Baines receives a $50,000 annual base salary. The terms
of the employment agreements are for three years following June 13, 2002 and automatically renew for one-year
terms unless written notice is provided by either party six months prior to the end of the current term.

These employment agreements also have the following provisions:

•

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

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

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

in the event any of the three executives is terminated without “cause”, or if they terminate for “good
reason”, or in the case of Lloyd McAdams or Joseph McAdams, their employment agreements are not
renewed, then the executives would be entitled to (1) all base salary due under the contracts,
(2) all discretionary bonus due under the contracts, (3) a lump sum payment of an amount equal to
three years of the executive’s then-current base salary, (4) payment of COBRA medical coverage for
eighteen months, (5) immediate vesting of all pension benefits, (6) all incentive compensation to which
the executives would have been entitled to under the contract prorated through the termination date,
and (7) all expense reimbursements and benefits due and owing the executives through the termination.
In addition, under these circumstances, Lloyd McAdams and Joseph McAdams would each be entitled
to a lump sum payment equal to 150% of the greater of (i) the highest amount paid or payable to all
employees under the 2002 Incentive Compensation Plan during any one of the three fiscal years prior
to their termination, and (ii) the highest amount paid, or that would be payable, under the plan during
any of the three fiscal years following their termination. Ms. Baines would also be entitled to a lump
sum payment equal to all incentive compensation that Ms. Baines would have been entitled to under
the plan during the three year period following her termination;

the three executives received restricted stock grants of 20,000 shares each, which grants vest in equal,
annual installments over ten years beginning June 13, 2002; and

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

At December 31, 2004, the value of the 48,000 unvested shares of restricted stock issued to the above

executives is reflected on our balance sheet as a reduction to stockholders’ equity. This amount is being
amortized to expense over the ten-year restricted period until such shares vest and is accounted for as unearned
restricted stock.

Agreements with Pacific Income Advisers, Inc.

On June 13, 2002, we entered into a sublease with Pacific Income Advisers, Inc., or PIA, a company owned

by a trust controlled by certain of our officers. Under the sublease, we lease 5,500 square feet of office space

F-25

ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

from PIA and pay at a rate equal to PIA’s obligation, currently $46.72 per square foot. The sublease runs through
June 30, 2012 unless earlier terminated pursuant to the master lease. During the year ended December 31, 2004,
we paid $253,196 in rent to PIA under the sublease which is included in “Other Expenses” on the consolidated
statements of income. During the year ended December 31, 2003, we paid $249,269 in rent to PIA under this
sublease.

The future minimum lease commitment is as follows:

Year

2005

2006

2007

Thereafter

Total
Commitment

Commitment Amount . . . . . . . . . . . . . . . . . .

$260,792

$268,611

$276,669

$1,350,241

$2,156,313

On October 14, 2002, we entered into an administrative agreement with PIA. Under the administrative

agreement, PIA provides administrative services and equipment to us in the nature of accounting, human
resources, operational support and information technology, and we pay an annual fee of 7 basis points on the first
$225 million of stockholders’ equity and 3.5 basis points thereafter (paid quarterly in advance) for those services.
The administrative agreement is for an initial term of one year and will renew for successive one year terms
thereafter unless either party gives notice of termination at least 90 days before the expiration of the then-current
annual term. We may also terminate the administrative agreement upon 30 days notice for any reason and
immediately if there is a material breach by PIA. Included in “Other Expenses” on the consolidated statements of
income are fees of $249,396 paid to PIA in connection with this agreement during the year ended December 31,
2004. During the year ended December 31, 2003, we paid fees of $197,360 to PIA in connection with this
agreement.

Belvedere Trust Mortgage Corporation

On November 3, 2003, we formed our wholly-owned subsidiary called Belvedere Trust Mortgage
Corporation, or Belvedere Trust. Belvedere Trust was formed to acquire, own and securitize mortgage loans,
with a focus on the high credit-quality jumbo adjustable-rate, hybrid and second-lien mortgage markets.
Belvedere Trust acquires mortgage loans, securitizes a substantial amount of these mortgage loans and then
retains a portion of those mortgage-backed securities, while pledging the balance to third parties in the secondary
market. The mortgage-backed securities it retains are purchased by one of our qualified REIT subsidiaries to
maximize tax efficiency on the interest income on those securities. Belvedere Trust was formed as a qualified
REIT subsidiary, but it structures securitizations through taxable REIT subsidiaries (which generally are taxed as
C corporations subject to full corporate taxation), which in turn establish special purpose entities that issue
securities through real estate mortgage investment conduit, or REMIC, trusts. Since its formation, Belvedere
Trust has become an increasingly important part of our overall operations and, at December 31, 2004, Belvedere
Trust’s assets comprised 37% of our overall assets. As of December 31, 2004, we had made an investment of
approximately $96 million in Belvedere Trust to capitalize its mortgage operations.

On November 3, 2003, we also formed BT Management Company, L.L.C., or BT Management, a Delaware

limited liability company that is owned 50% by us, 27.5% by Claus Lund, the Chief Executive Officer of
Belvedere Trust, 17.5% by Russell J. Thompson, the Chief Financial Officer of Belvedere Trust, and 5% by
Lloyd McAdams, our Chairman and Chief Executive Officer. BT Management has entered into a management
agreement with Belvedere Trust pursuant to which BT Management will manage the day-to-day operations of
Belvedere Trust in exchange for an annual base management fee and a quarterly incentive fee. The annual base
management fee is equal to 1.15% of the first $300 million of average net invested assets (as defined in the
management agreement), plus 0.85% of the portion above $300 million. The incentive fee for each fiscal quarter
is equal to 20% of the amount of net income of Belvedere Trust, before incentive compensation, for such quarter

F-26

ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

in excess of the amount that would produce an annualized return on equity (calculated by multiplying the return
on equity for such fiscal quarter by four) equal to the Ten-Year U.S. Treasury Rate for such fiscal quarter
plus 1%.

The management agreement requires that Belvedere Trust pay all amounts earned thereunder each quarter

(subject to offset for accrued negative incentive compensation). For the year ended December 31, 2004,
Belvedere Trust paid BT Management incentive compensation of $714,000.

Certain of our executive officers serve as officers and directors of Belvedere Trust and officers and

managers of BT Management (and certain of our employees are also employees of BT Management). Our
employees who are also employed by BT Management may receive compensation from BT Management in the
form of salary, employee benefits and incentive compensation. The compensation of all BT Management
employees is the responsibility of the BT Management board of directors. However, compensation paid by
BT Management to our executive officers who also serve as officers, managers or employees of BT Management
is subject to approval of the compensation committee of Anworth’s board of directors.

BT Management has also entered into employment agreements with Messrs. Lund and Thompson whereby
Mr. Lund serves as the President of BT Management and Mr. Thompson serves as Executive Vice President and
Treasurer of BT Management. The employment agreements are for a term of three years and automatically renew
for one-year terms unless written notice is provided by either party ninety days prior to the end of the current
term.

Deferred Compensation Plan

On January 15, 2003, we adopted the Anworth Mortgage Asset Corporation Deferred Compensation Plan,

or the Deferred Compensation Plan. We amended the plan effective January 1, 2005 to comply with Section
409A of the Code enacted as part of the American Jobs Creation Act of 2004. The Deferred Compensation Plan
permits our eligible officers to defer the payment of all or a portion of their cash compensation that otherwise
would be in excess of the $1,000,000 annual limitation on deductible compensation imposed by Section 162(m)
of the Code (based on the officers’ compensation and benefit elections made prior to January 1 of the calendar
year in which the compensation will be deferred). Under this limitation, compensation paid to our Chief
Executive Officer and our four other highest paid officers is not deductible by us for income tax purposes to the
extent the amount paid to any such officer exceeds $1,000,000 in any calendar year, unless such compensation
qualifies as performance-based compensation under Section 162(m). Our board of directors designates the
eligible officers who may participate in the Deferred Compensation Plan from among the group consisting of our
Chief Executive Officer and our other four highest paid officers. To date, the board has designated Lloyd
McAdams, our Chairman, President and Chief Executive Officer, and Joseph McAdams, our Chief Investment
Officer and Executive Vice President, as the only officers who may participate in the Deferred Compensation
Plan. Each eligible officer becomes a participant in the Deferred Compensation Plan by making a written election
to defer the payment of cash compensation. With certain limited exceptions, the election must be filed with us
before January 1 of the calendar year in which the compensation will be deferred. The election is effective for the
entire calendar year and may not be terminated or modified for that calendar year. If a participant wishes to defer
compensation in a subsequent calendar year, a new deferral election must be made before January 1 of that
subsequent year.

Amounts deferred under the Deferred Compensation Plan are not paid to the participant as earned, but are

credited to a bookkeeping account maintained by us in the name of the participant. The balance in the
participant’s account is credited with earnings at a rate of return equal to the annual dividend yield on our

F-27

ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

common stock. The balance in the participant’s account is paid to the participant six months after termination of
employment or upon the death of the participant or a change in control of our company. Each participant is a
general unsecured creditor of our company with respect to all amounts deferred under the plan.

NOTE 10. STOCK OPTION PLAN

At our May 27, 2004 annual stockholders’ meeting, our stockholders adopted the Anworth Mortgage Asset

Corporation 2004 Equity Compensation Plan, or the Stock Option Plan, which amended and restated our 1997
Stock Option and Awards Plan. The Stock Option Plan authorized the grant of stock options and other
stock-based awards, as of December 31, 2004, for an aggregate of up to 3,500,000 of the outstanding shares of
our common stock. The plan authorizes our board of directors, or a committee of our board, to grant incentive
stock options, as defined under section 422 of the Internal Revenue Code of 1986, as amended, options not so
qualified, restricted stock, dividend equivalent rights (DERs), phantom shares, stock-based awards that qualify as
performance-based awards under Section 162(m) of the Internal Revenue Code, and other stock-based awards.
The exercise price for any option granted under the Stock Option Plan may not be less than 100% of the fair
market value of the shares of common stock at the time the option is granted. As of December 31, 2004,
1,639,804 shares remained available for future issuance under the Stock Option Plan through any combination of
stock options or other awards. The Stock Option Plan does not provide for automatic annual increases in the
aggregate share reserve or the number of shares remaining available for grant.

A summary of stock option transactions for the plan follows:

Outstanding, beginning of year
. . . . . . . . . . . .
Granted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Exercised . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Expired . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2004

2003

2002

Weighted
Average
Exercise
Price

$11.719
12.47
10.116
—

Weighted
Average
Exercise
Price

$10.096
13.80
9.63
—

655,719
427,300
(83,305)
—

999,174
452,000
(67,504)
—

Weighted
Average
Exercise
Price

$ 7.577
10.712
7.149
—

395,539
494,245
(234,605)

—

Outstanding, end of year . . . . . . . . . . . . . . . . . .

1,383,670

$12.042

999,174

$11.719

655,179

$10.096

Weighted average fair value of options granted
during the year . . . . . . . . . . . . . . . . . . . . . . .
Options exercisable at year end . . . . . . . . . . . .

1.23
1,063,670

0.92
571,874

0.31
299,179

F-28

ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The following table summarizes information about stock options outstanding at December 31, 2004:

Exercise
Price

$ 4.60
$ 6.70
$ 7.10
$ 7.37
$ 7.81
$ 9.00
$ 9.45
$11.20
$11.25
$13.80
$12.47

Options
Outstanding

2,644
520
9,000
—
25,000
65,961
127,245
264,000
10,000
427,300
452,000

1,383,670

Remaining
Contractual
Life (Yrs.)

4.3
6.5
6.6
1.5
1.6
3.2
7.1
7.8
7.8
8.3
4.3

Exercisable
at 12/31/04

2,644
520
9,000
—
25,000
65,961
127,245
264,000
10,000
427,300
132,000

1,063,670

NOTE 11. HEDGING INSTRUMENTS

At December 31, 2004, we were a counter-party to swap agreements, which are derivative instruments as

defined by FASB 133 and FASB 138, with an aggregate notional amount of $400 million and an average
maturity of 3.6 years. We utilize swap agreements to manage interest rate risk and do not anticipate entering into
derivative transactions for speculative or trading purposes. In accordance with the swap agreements, we will pay
a fixed rate of interest during the term of the swap agreements and receive a payment that varies with the
three-month LIBOR rate.

At December 31, 2004, there were unrealized gains of $4.1 million on our swap agreements included in

Other Comprehensive Income (consisting of unrealized losses on cash flow hedges of $0.1 million and a
reclassification adjustment for interest expense included in net income of $4.2 million) and shown as derivative
instruments at fair value on the consolidated balance sheets as an asset of $6.4 million and a liability of $2.3
million.

For the year ending December 31, 2004, there was a net gain of $1,456 recognized in earnings due to hedge

ineffectiveness. There were no components of the derivative instruments’ gain or loss excluded from the
assessment of hedge effectiveness. As of December 31, 2004, the estimated amount of net losses that is expected
to be reclassified into earnings within the next 12 months due to the variability of cash flows of the hedged
transactions (i.e., when the periodic settlement interest payments are due) is $1.4 million. The maximum length
of our swap agreements is 4.5 years. We do not anticipate any discontinuance of the swap agreements and thus
do not expect to recognize any gain or loss into earnings because of this.

During the year ended December 31, 2004, we also entered in Eurodollar transactions in order to mitigate
the impact of rising interest rates on planned securitization funding. There is usually a time difference between
the date we enter into an agreement to purchase whole loans and the date on which we fix the interest rates paid
for securitization financing. We are exposed to interest rate fluctuations during this period. In order to mitigate
this risk, we hedge our position using Eurodollar futures. Once the financing rates on the securitization are fixed,
we remove the hedge positions.

Belvedere Trust recognized gains, net of recognized losses, of $340,000 on Eurodollar futures during the

year ended December 31, 2004.

F-29

ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

As of December 31, 2004, we did not have any positions outstanding on Eurodollar futures transactions. It is

possible that Belvedere Trust may enter into Eurodollar futures transactions within the next twelve months. As
the transactions are short term, there may be either gain or loss recognized into earnings but we can not anticipate
the amount that would be recognized within the next twelve months at this time.

As of December 31, 2004, the Company had entered into approximately $351 million in forward loan

purchase commitments for which the market value had not significantly fluctuated from the inception
of the commitment to December 31, 2004. These forward loan purchase commitments did not experience
significant fluctuations in value during the periods for which the commitments were open.

NOTE 12. COMMITMENTS AND CONTINGENCIES

(a) Lease Commitment and Administrative Services Commitment—The Company subleases office space

and uses administrative services from PIA, as more fully described in Note 9.

(b) Loan Purchase Commitment—As of December 31, 2004, Belvedere Trust has entered into

commitments to purchase mortgage loans in the amount of $351 million.

NOTE 13. OTHER EXPENSE

Schedule of Other Expense
(in thousands)
Year ended December 31,

2004

2003

2002

Professional services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Fees related to loan acquisitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Printing and stockholder communications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
D&O insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Software and implementation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Administrative service fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Rent
Fees relating to stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Consulting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 803
528
231
359
293
277
275
273
182
545

$ 377
—
155
328
99
197
249
318
—
620

$ 395
—
138
129
—
40
133
58
—
203

Total of Other Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$3,766

$2,343

$1,096

F-30

ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

NOTE 14. SUMMARIZED QUARTERLY RESULTS (UNAUDITED)

The following tables summarize quarterly results for the years ended December 31, 2004 and 2003
(unaudited). Earnings per share amounts for each quarter and the full years have been calculated separately.
Accordingly, quarterly amounts may not add to the annual amounts because of substantial differences in the
average shares outstanding during each period and, with regard to diluted earnings per share amounts, they may
also differ because of the inclusion of the effect of potentially dilutive securities only in the periods in which
such effect would have been dilutive.

For the year ended December 31, 2004 (in thousands, except per share amounts):

First
Quarter

Second
Quarter

Third
Quarter

Fourth
Quarter

. . . . .
Interest income net of amortization of premium and discount
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 35,246
(14,940)

$ 32,904
(19,346)

$ 42,367
(27,575)

$ 52,506
(36,088)

Net interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Gain on sale of securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net gain on derivative instruments . . . . . . . . . . . . . . . . . . . . . . . . . .
Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

20,306
157
(203)
(2,387)

13,558
102
532
(1,820)

14,792
1
(59)
(2,496)

16,418
(1)
70
(2,872)

Income from operations before income taxes and minority

interest

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Minority interest in net income of a subsidiary . . . . . . . . . . . . . . . . .

17,873
—
—

12,372
(79)
(103)

12,238
—
(72)

13,615
79
(118)

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 17,873

$ 12,190

$ 12,166

$ 13,576

Dividend on preferred stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

—

(369)

Net income available to common stockholders . . . . . . . . . . . . . . . . .

$ 17,873

$ 12,190

$ 12,166

$ 13,207

Basic earnings per share available to common stockholders . . . . . . .
Diluted earnings per share available to common stockholders . . . . .
Average number of diluted shares outstanding . . . . . . . . . . . . . . . . .

$
$

0.41
0.41
43,823

$
$

0.27
0.27
45,101

$
$

0.27
0.26
45,925

$
$

0.29
0.28
46,434

For the year ended December 31, 2003 (in thousands, except per share amounts):

First
Quarter

Second
Quarter

Third
Quarter

Fourth
Quarter

Interest income net of amortization of premium and discount
. . . . .
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 23,327
(10,210)

$ 24,370
(10,802)

$ 22,774
(11,647)

$ 29,606
(13,002)

Net interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Gain on sale of securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

13,117
652
(1,947)

13,568
2,140
(2,136)

11,127
706
(1,466)

16,604
—
(2,170)

Net income available to common stockholders . . . . . . . . . . . . . . . . .

$ 11,822

$ 13,572

$ 10,367

$ 14,434

$
$

0.46
0.46
25,926

$
$

0.45
0.45
30,147

$
$

0.29
0.29
35,618

$
$

0.36
0.35
40,660

F-31

ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

NOTE 15. SUBSEQUENT EVENTS

On January 19, 2005, we entered into an Amended and Restated Sales Agreement with Cantor to sell up to

2.0 million shares of our Series A Preferred Stock, and up to 5.7 million shares of our Common Stock, from time
to time through a controlled equity offering program under which Cantor acts as sales agent. The agreement
amended and restated the Sales Agreement that we entered into on April 21, 2004 with Cantor. Sales of the
shares of our Series A Preferred Stock and Common Stock are made on the New York Stock Exchange by means
of ordinary brokers’ transactions at market prices and through privately negotiated transactions. From January
19, 2005 through March 14, 2005, we sold 509,200 shares of Series A Preferred Stock under the controlled
equity offering program which provided net proceeds to us of approximately $12.6 million. The sales agent
received an aggregate of approximately $337,000, which represents an average commission of approximately
2.6% on the gross sales price per share.

F-32

Exhibit
Number

EXHIBIT INDEX

Description

3.1

Amended Articles of Incorporation of Anworth (incorporated by reference from our Registration

Statement on Form S-11, Registration No. 333-38641, which became effective under the Securities
Act of 1933 on March 12, 1998)

3.2

Articles of Amendment to Amended Articles of Incorporation (incorporated by reference from our

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

3.3

3.4

3.5

4.1

Articles Supplementary for Series A Cumulative Preferred Stock (incorporated by reference from our
Current Report on Form 8-K filed with the Securities and Exchange Commission on November 3,
2004)

Articles Supplementary for Series A Cumulative Preferred Stock (incorporated by reference from our
Current Report on Form 8-K filed with the Securities and Exchange Commission on January 21,
2005)

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

4.2

Specimen Series A Cumulative Preferred Stock Certificate (incorporated by reference from our

Current Report on Form 8-K filed with the Securities and Exchange Commission on November 3,
2004)

10.1

2004 Equity Compensation Plan (incorporated by reference from our Definitive Proxy Statement

filed pursuant to Section 14(a) of the Securities Exchange Act of 1934, as filed with the Securities
and Exchange Commission on April 26, 2004)

10.2

10.3

10.4

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

Agreement and Plan of Merger dated April 18, 2002 by and among Anworth, Anworth Mortgage
Advisory Corporation (the “Manager”) and the shareholder of the Manager (incorporated by
reference from our Definitive Proxy Statement filed pursuant to Section 14(a) of the Securities
Exchange Act of 1934, as filed with the Securities Exchange Commission on May 17, 2002)

10.5

Employment Agreement dated January 1, 2002, between the Manager and Lloyd McAdams

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

10.6

Employment Agreement dated January 1, 2002, between the Manager and Heather U. Baines

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

10.7

Employment Agreement dated January 1, 2002, between the Manager and Joseph E. McAdams

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

Exhibit
Number

10.8

Description

Addendum to Employment Agreement dated April 18, 2002, among Anworth, the Manager and
Lloyd McAdams (incorporated by reference from our Quarterly Report on Form 10-Q for the
quarter ended June 30, 2002, as filed with the Securities and Exchange Commission on August 14,
2002)

10.9

Addendum to Employment Agreement dated April 18, 2002, among Anworth, the Manager and

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

10.10

Addendum to Employment Agreement dated April 18, 2002, among Anworth, the Manager and

10.11

10.12

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

Second Addendum to Employment Agreement dated as of May 28, 2004 between Anworth and
Lloyd McAdams (incorporated by reference from our Quarterly Report on Form 10-Q for the
quarter ended June 30, 2004, as filed with the Securities and Exchange Commission on August 9,
2004)

Second Addendum to Employment Agreement dated as of June 13, 2002 by and among Anworth and
Joseph E. McAdams (incorporated by reference from our Quarterly Report on Form 10-Q for the
quarter ended June 30, 2002, as filed with the Securities and Exchange Commission on August 14,
2002)

10.13

Third Addendum to Employment Agreement dated as of May 28, 2004, between Anworth and

Joseph E. McAdams (incorporated by reference from our Quarterly Report on Form 10-Q for the
quarter ended June 30, 2004, as filed with the Securities and Exchange Commission on August 9,
2004)

10.14

Sublease dated June 13, 2002, between Anworth and Pacific Income Advisers, Inc. (incorporated by
reference from our Quarterly Report on Form 10-Q for the quarter ended June 30, 2002, as filed
with the Securities and Exchange Commission on August 14, 2002)

10.15

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

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

10.16

10.17

10.18

Deferred Compensation Plan (incorporated by reference from our Annual Report on Form 10-K for
the year ended December 31, 2002, as filed with the Securities and Exchange Commission on
March 26, 2003)

10.19

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

Mortgage Corporation (incorporated by reference from our Quarterly Report on Form 10-Q for the
quarter ended September 30, 2003, as filed with the Securities and Exchange Commission on
November 13, 2003)

Exhibit
Number

10.20

Description

Employment Agreement dated November 3, 2003 between BT Management and Claus Lund
(incorporated by reference from our Quarterly Report on Form 10-Q for the quarter ended
September 30, 2003, as filed with the Securities and Exchange Commission on November 13,
2003)

10.21

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

Thompson (incorporated by reference from our Quarterly Report on Form 10-Q for the quarter
ended September 30, 2003, as filed with the Securities and Exchange Commission on
November 13, 2003)

10.22

Amended and Restated Sales Agreement dated January 19, 2005 between Anworth and Cantor

Fitzgerald & Co. (incorporated by reference from our Current Report on Form 8-K filed with the
Securities and Exchange Commission on January 21, 2005)

10.23

Sublease dated January 6, 2005 between Belvedere Trust Mortgage Corporation and Keefe,

21.1

23.1

23.2

31.1

Bruyette & Woods, Inc.

List of Subsidiaries

Consent of BDO Seidman, LLP

Consent of PricewaterhouseCoopers LLP

Certification of the Chief Executive Officer, as required by Rule 13a-14(a) of the Securities

Exchange Act of 1934

31.2

Certification of the Chief Financial Officer, as required by Rule 13a-14(a) of the Securities Exchange

Act of 1934

32.1

Certifications of the Chief Executive Officer provided pursuant to 18 U.S.C. Section 1350 as adopted

pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

32.2

Certifications of the Chief Financial Officer provided pursuant to 18 U.S.C. Section 1350 as adopted

pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

[THIS PAGE INTENTIONALLY LEFT BLANK]

Anworth Mortgage Asset Corporation

2004 Annual Report

Corporate Information

DIRECTORS

EXECUTIVE OFFICES

Lloyd McAdams
Chairman of the Board of Directors, President
and Chief Executive Officer

Joseph E. McAdams
Chief Investment Officer, Executive Vice President
and Director

Lee A. Ault, III
Director

Charles H. Black
Director

Joe E. Davis
Director

Charles F. Smith
Director

EXECUTIVE OFFICERS

Thad M. Brown
Chief Financial Officer
and Secretary

Heather U. Baines
Executive Vice President

Charles J. Siegel
Senior Vice President

Evangelos Karagiannis
Vice President

Bistra Pashamova
Vice President

Anworth Mortgage Asset Corporation
1299 Ocean Avenue, Suite 250
Santa Monica, CA 90401
Tel. (310) 255-4493

Transfer Agent and Registrar

American Stock Transfer & Trust Company
59 Maiden Lane
Plaza Level
New York, NY 10038
Tel. (212) 936-5100

Registered Independent Public Accounting Firm

BDO Seidman, LLP
1900 Avenue of the Stars, 11th Floor
Los Angeles, CA 90067

Legal Counsel

Manatt, Phelps & Phillips, LLP
11355 W. Olympic Boulevard
Los Angeles, CA 90064

Investor Relations

Any stockholder wishing a copy of the Company’s
annual report on Form 10-K or the quarterly report
on Form 10-Q, as filed with the Securities and
Exchange Commission, may obtain such report,
without charge, upon written request to the
Company, Attn: Investor Relations.

Stock Listing

The Company’s Series A Cumulative Preferred Stock
is traded on the New York Stock Exchange (Symbol:
ANHPrA). The Company’s Common Stock is traded
on the New York Stock Exchange (Symbol: ANH).

Annual Meeting of Stockholders

Our Annual Meeting of Stockholders will be held at
10:00 a.m. on Friday, May 27, 2005 at the offices of
the Company (address above).

Anworth Mortgage Asset Corporation
1299 Ocean Avenue, Suite 250
Santa Monica, CA 90401
phone: (310) 255-4493
fax: (310) 434-0070
www.anworth.com
Traded on the New York Stock Exchange
Series A Cumulative Preferred Stock symbol “ANHPrA”
Common Stock symbol “ANH”