The following discussion should be read in conjunction with our financial statements and the related notes included in Item 8-Financial Statements and Supplementary Information in this Annual Report on 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, but not limited to, those disclosed in Item 1A-Risk Factors and elsewhere in this Annual Report on Form 10-K.

General

We were formed in October 1997 and commenced operations on March 17, 1998. We are in the business of investing primarily in United States agency mortgage-backed securities, or MBS, which are obligations guaranteed by the United States government, such as Ginnie Mae, or federally sponsored enterprises such as Fannie Mae or Freddie Mac. Our principal business objective is to generate net income for distribution to stockholders based upon the spread between the interest income on our mortgage-related assets and the costs of borrowing to finance our acquisition of these assets.

We are organized for tax purposes as a real estate investment trust, or 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. At December 31, 2008, our qualified REIT assets (real estate assets, as defined in the Internal Revenue Code, or Code, cash and cash items and government securities) were greater than 90% of our total assets, as compared to the Code requirement that at least 75% of our total assets must be qualified REIT assets. Greater than 99% of our 2008 revenue qualifies for both the 75% source of income test and the 95% source of income test under the REIT rules. We believe we currently meet all REIT requirements regarding the ownership of our common stock and the distributions of our net income. Therefore, we believe that we continue to qualify as a REIT under the provisions of the Code.

During the past several months, the credit and liquidity problems surrounding the mortgage markets and impacting the U.S. economy generally have deepened, placing severe pressure on liquidity and asset values. Several large U.S. financial and investment institutions were either seized by federal regulators (Bear Stearns, IndyMac Bancorp and Washington Mutual) or, after experiencing financial difficulties, were acquired by other large companies (Wachovia Corporation was acquired by Wells Fargo & Company). Lehman Brothers Holdings Inc., a major investment bank, experienced a major liquidity crisis and declared bankruptcy. On September 16, 2008, the U.S. government announced that it would lend approximately $85 billion (which was subsequently increased to $150 billion) to American International Group to avert a similar liquidity crisis and potential bankruptcy. At the end of September 2008 and in early October 2008, several large European banks all received either assistance from their respective governments or were acquired by other large global banks. These events may impact the availability of financing generally in the marketplace and also may impact the market value of MBS generally, including the securities we currently own in our portfolio.

The U.S. government and other governments have taken various actions. On September 7, 2008, the U.S. government placed Fannie Mae and Freddie Mac under its conservatorship as part of the recent enactment of the Housing and Economic Recovery Act of 2008, or the Act. The Act also seeks to forestall home foreclosures for distressed borrowers and assist communities with foreclosure problems. The Emergency Economic Stabilization Act of 2008, or EESA, was also enacted. The EESA provides the U.S. Secretary of the Treasury with various authority including to establish a Troubled Asset Relief Program, or TARP, to purchase from financial institutions up to $700 billion of residential and commercial mortgages. Under the TARP, the U.S. government has invested approximately $250 billion into hundreds of the country's banks. In addition, the EESA increases FDIC deposit insurance limits temporarily (until December 2009) from $100 thousand to $250 thousand. The U.S. government and various U.S. government agencies have also enacted programs in an effort to increase

liquidity in the financial markets. Other global governments have injected capital into troubled institutions in their countries, made loans, made promises of continued liquidity funding and have also worked with large institutions to acquire troubled institutions. Recently, the U.S. government, many European governments and other governments of more economically developed countries (such as New Zealand, Australia, Japan and Saudi Arabia) have all instituted interest rate cuts to help stimulate their economies.

Although these various actions by both the U.S. government and other governments are intended to protect financial institutions, their respective economies and their respective housing markets, we continue to operate under very difficult market conditions. There can be no assurance that these various actions will have a beneficial impact on the global financial markets. We cannot predict what, if any, impact these actions or future actions by either the U.S. government or foreign governments could have on our business, results of operations and financial condition.

Our continuing operations consist of the following portfolios: agency mortgage-backed securities, or Agency MBS, and non-agency mortgage-backed securities, or Non-Agency MBS.

At December 31, 2008, we had total assets of $5.48 billion. Our Agency MBS portfolio, consisting of $5.3 billion, was distributed as follows: 15% agency adjustable-rate MBS, 65% agency hybrid adjustable-rate MBS, 20% agency fixed-rate MBS and less than 1% agency floating-rate CMOs. Our Non-Agency MBS portfolio consisted of approximately $7.3 million of floating-rate CMOs. Stockholders' equity available to common stockholders at December 31, 2008 was approximately $507.3 million, or $5.61 per share. The $507.3 million equals total stockholders' equity of $556.2 million less the Series A Preferred Stock liquidating value of approximately $46.9 million and less the difference between the Series B Preferred Stock liquidating value of $30.1 million and the proceeds from its from its sale of $28.1 million. For the year ended December 31, 2008, we reported net income of $62.6 million. Net income to common stockholders was $56.7 million, or net income of $0.69 per diluted share, based on a weighted average of 85.3 million fully diluted shares outstanding, which consisted of net income of $62.6 million minus payment of preferred dividends of $5.9 million. This includes approximately $38 million in impairment charges on our Non-Agency MBS portfolio and a gain on the disposition of discontinued operations of approximately $7.6 million.

Results of Operations

Years Ended December 31, 2008 and 2007

For the year ended December 31, 2008, our net income was $62.6 million. Our net income available to common stockholders was $56.7 million, or $0.69 per diluted share, based on a weighted average of 85.3 million fully diluted shares outstanding. This includes net income of $62.6 million minus the payment of preferred dividends of $5.9 million. For the year ended December 31, 2007, our net loss was $156.5 million. Our 2007 net loss to common stockholders was $161.2 million, or a net loss of $(3.47) per diluted share, based on an average of 46.5 million shares outstanding. The 2007 loss includes a loss from continuing operations of $5.2 million (due primarily to a loss of $23.4 million on the sale of approximately $904 million of our Agency MBS and Non-Agency MBS) and a loss from discontinued operations of $151.3 million (due to the sales and seizures by lenders and write-offs of the assets of Belvedere Trust Mortgage Corporation and subsidiaries, or Belvedere Trust).

Net interest income for the year ended December 31, 2008 totaled $106.4 million or 36% of gross income, compared to $23.9 million, or 8.9% of gross income, for the year ended December 31, 2007. The increase in net interest income is due primarily to the increase in our investments in Agency MBS (based on leverage on approximately $250 million in capital raised during the year ended December 31, 2008). Net interest income is comprised of the interest income earned on mortgage investments (net of premium amortization expense) less interest expense from borrowings. Interest income net of premium amortization expense for the year ended December 31, 2008 was $287.7 million, compared to $248.8 million for the year ended December 31, 2007, an

increase of 16% (due primarily to an increase in the size of the portfolio). Interest expense for the year ended December 31, 2008 was $181.3 million, compared to $224.9 million for the year ended December 31, 2007, a decrease of 19%, which resulted from a decline in short-term interest rates.

The results of our operations are affected by a number of factors, many of which are beyond our control, and primarily depend on, among other things, the level of our net interest income, the market value of our MBS, the supply of, and demand for, MBS in the marketplace, and the terms and availability of financing. Our net interest income varies primarily as a result from changes in interest rates, the slope of the yield curve (the differential between long-term and short-term interest rates), borrowing costs (our interest expense) and prepayment speeds on our MBS portfolios, the behavior of which involves various risks and uncertainties. Interest rates and prepayment speeds, as measured by the constant prepayment rate, vary according to the type of investment, conditions in the financial markets, competition and other factors, none of which can be predicted with any certainty. With respect to our business operations, increases in interest rates, in general, may, over time, cause:
(i) the interest expense associated with our borrowings, which are primarily comprised of repurchase agreements, to increase; (ii) the value of our MBS portfolios and, correspondingly, our stockholders' equity to decline;
(iii) coupons on our MBS to reset, although on a delayed basis, to higher interest rates; (iv) prepayments on our MBS portfolios to slow, thereby slowing the amortization of our MBS purchase premiums; and (v) the value of our interest rate swap agreements and, correspondingly, our stockholders' equity to increase. Conversely, decreases in interest rates, in general, may, over time, cause:
(i) prepayments on our MBS portfolios to increase, thereby accelerating the amortization of our MBS purchase premiums; (ii) the interest expense associated with our borrowings to decrease; (iii) the value of our MBS portfolios and, correspondingly, our stockholders' equity to increase; (iv) the vale of our interest rate swap agreements and, correspondingly, our stockholders' equity to decrease; and (v) coupons on our MBS to reset, although on a delayed basis, to lower interest rates. In addition, our borrowing costs and credit lines are further affected by the type of collateral pledged and general conditions in the credit markets.

During the year ended December 31, 2008, premium amortization expense for Anworth decreased $9.1 million, or 43%, from $21.1 million during the year ended December 31, 2007 to $12.0 million. During the year ended December 31, 2008, the decrease in premium amortization expense for Anworth resulted from a decrease in the constant prepayment rate, or CPR, of our portfolio.

The table below shows the approximate constant prepayment rate of our Agency MBS and Non-Agency MBS:

                                   Year Ended December 31, 2008                        Year Ended December 31, 2007
                           First       Second        Third       Fourth        First       Second        Third       Fourth
Portfolio                 Quarter      Quarter      Quarter      Quarter      Quarter      Quarter      Quarter      Quarter
Agency MBS and
Non-Agency MBS                 18 %         18 %         14 %         10 %         24 %         25 %         23 %         18 %

During the year ended December 31, 2008, we sold approximately $26.6 million of Agency MBS (relating to the close-out of our repurchase agreement borrowings with Lehman Brothers Special Finance), resulting in a loss of approximately $49 thousand. These sales were in connection with the bankruptcy of Lehman Brothers Holdings Inc. and we do not anticipate any other sales in connection with bankruptcies unless one of our other counterparties defaults. During the year ended December 31, 2007, we sold approximately $904 million of Agency MBS and Non-Agency MBS, resulting in a loss of approximately $23.4 million. The sales in 2007 were in response to liquidity concerns in the marketplace.

During the year ended December 31, 2008, we have recognized through earnings impairment charges of approximately $38 million on our Non-Agency MBS portfolio, with approximately $34 million being recognized during the third quarter ended September 30, 2008 and approximately $4 million being recognized during the fourth quarter ended December 31, 2008. Of these amounts, approximately $22 million had previously been shown as "unrealized loss" in "other comprehensive income" of stockholders' equity at June 30, 2008. As we currently believe this decline in fair value is likely to be other-than-temporary, we have recognized an

impairment charge to write these securities down to their estimated fair value. Some of the factors considered in our assessment included: (1) the expected cash flows from these investments; (2) whether there has been an other-than-temporary deterioration of the credit quality of the underlying mortgages; (3) the credit protection available to the related mortgage pools; (4) any other market information available; (5) management's internal analysis of the securities considering all relevant information at the time of the assessment; and (6) the magnitude and duration of the historical decline in market prices. Because our assessment was based on both factual and subjective information available at the time of the assessment, the determination of the amount considered impaired is subjective and therefore constitutes material estimates that are susceptible to significant change.

During the year ended December 31, 2008, there was a net loss of approximately $113 thousand recognized in earnings due to hedge ineffectiveness, compared to a net loss of approximately $147 thousand due to hedge ineffectiveness during the year ended December 31, 2007. We have determined that our hedges are still considered "highly effective." There were no components of the derivative instruments' gain or loss excluded from the assessment of hedge effectiveness.

In September 2008, the assets of Belvedere Trust and the assets of BT Management Company, L.L.C., or BT Management, were assigned for the benefit of their creditors to an independent third party. As control of these operations was turned over to this third party, Belvedere Trust and BT Management have been deconsolidated, and we recognized a gain on the disposition of discontinued operations of approximately $7.6 million during the year ended December 31, 2008. As a result, there were no remaining assets or liabilities of discontinued operations at December 31, 2008. At December 31, 2007, there were approximately $38 thousand in assets of discontinued operations and approximately $7.8 million in liabilities of discontinued operations.

Total expenses were $13.6 million for the year ended December 31, 2008, compared to $5.5 million for the year ended December 31, 2007. The increase of $8.1 million in total expenses was due primarily to an increase in compensation costs of $1.6 million (due to increased salaries and bonuses), the payment of $5.8 million in incentive compensation (primarily related to and in accordance with senior executive employment agreements), an increase in "Other expenses" (as detailed in Note 14 to the accompanying audited financial statements) of $248 thousand, an increase in compensation costs relating to amortization of restricted stock of $299 thousand and the write-off of common stock offering costs of $114 thousand.

Years Ended December 31, 2007 and 2006

For the year ended December 31, 2007, our net loss was $156.5 million. Our net loss to common stockholders was $161.2 million, or a net loss of $(3.47) per diluted share, based on a weighted average of 46.5 million fully diluted shares outstanding. This includes a loss from continuing operations of $5.2 million (due primarily to a loss of $23.4 million on the sale of approximately $904 million of our Agency MBS and Non-Agency MBS) and a loss from discontinued operations of $151.3 million (due to the sales, seizures by lenders and write-offs of Belvedere Trust's assets). This net loss on discontinued operations also included an amount equal to approximately $8 million related to three claims against Belvedere Trust, which have been contested, relating to repurchase agreement transactions. Anworth is neither a co-party to nor a guarantor of Belvedere Trust's repurchase agreements or any claims against Belvedere Trust. For the year ended December 31, 2006, our net loss was $14.2 million. Our net loss to common stockholders was $18.2 million, or a net loss of $(0.40) per diluted share, based on an average of 45.4 million shares outstanding. This includes a loss from continuing operations of $11.4 million (due primarily to a loss of $10.2 million on the sale of approximately $398 million of our Agency MBS) and a loss from discontinued operations of $2.8 million.

Net interest income for the year ended December 31, 2007 totaled $23.9 million or 8.9% of gross income, compared to $4.3 million, or 1.8% of gross income, for the year ended December 31, 2006. The increase in net interest income is due primarily to the increase in interest rates of our MBS investments. Net interest income is comprised of the interest income earned on mortgage investments (net of premium amortization expense) less interest expense from borrowings. Interest income net of premium amortization expense for the year ended

December 31, 2007 was $248.8 million, compared to $206.3 million for the year ended December 31, 2006, an increase of 20.6%. Interest expense for the year ended December 31, 2007 was $224.9 million, compared to $202.0 million for the year ended December 31, 2006, an increase of 11.3%. The increase in interest expense was due primarily to the increases in short-term rates later in the year, which we believe arose from liquidity and credit concerns surrounding the mortgage markets generally, which in turn caused lenders to be more cautious and resulted in increases in the borrowing rate as well as more limited financing.

During the year ended December 31, 2007, premium amortization expense for Anworth decreased $6.5 million, or 23.6%, from $27.6 million during the year ended December 31, 2006 to $21.1 million. During the year ended December 31, 2007, the decrease in premium amortization expense for Anworth resulted from a decrease in the constant prepayment rate of our portfolio.

The table below shows the approximate constant prepayment rate of our Agency MBS and Non-Agency MBS:

                                   Year Ended December 31, 2007                        Year Ended December 31, 2006
                           First       Second        Third       Fourth        First       Second        Third       Fourth
Portfolio                 Quarter      Quarter      Quarter      Quarter      Quarter      Quarter      Quarter      Quarter
Agency MBS and
Non-Agency MBS                 24 %         25 %         23 %         18 %         25 %         29 %         26 %         26 %

During the year ended December 31, 2007, we sold approximately $904 million of Agency MBS and Non-Agency MBS, resulting in a loss of approximately $23.4 million. During the year ended December 31, 2006, we sold approximately $398 million in face amount of Agency MBS, resulting in a loss of approximately $10.2 million, as part of our asset/liability management program. The proceeds from the sale were used to invest in higher-yielding Agency MBS.

Total expenses were approximately $5.5 million for the year ended December 31, 2007, compared to approximately $5.5 million for the year ended December 31, 2006. The increase of $52 thousand in total expenses was due primarily to an increase in compensation costs of $139 thousand, an increase in "Other expenses" of $407 thousand partially offset by a decrease in compensation costs relating to amortization of restricted stock of $494 thousand.

Discontinued Operations

During the year ended December 31, 2007, there was a net loss from discontinued operations of $151.3 million, compared to a net loss of $2.8 million for the year ended December 31, 2006. The net loss in 2007 from discontinued operations of $151.3 million was due to the sales, seizures by lenders and write-offs of Belvedere Trust's assets. This net loss on discontinued operations also included an amount equal to approximately $8 million related to three claims against Belvedere Trust, which have been contested, relating to repurchase agreement transactions. Anworth was neither a co-party to nor a guarantor of Belvedere Trust's repurchase agreements or any claims against Belvedere Trust.

Net interest income (expense) for the year ended December 31, 2007 was $4.4 million, compared to $(2.0) million for the year ended December 31, 2006. Net interest income is comprised of interest income earned on mortgage investments (net of premium amortization expense) less interest expense on borrowings. Interest income net of premium amortization expense for the year ended December 31, 2007 was $66.7 million compared to $103.1 million for the year ended December 31, 2006, a decrease of 35.3%. Interest expense for the year ended December 31, 2007 was $62.3 million compared to $105.1 million for the year ended December 31, 2006, a decrease of 40.7%. The decrease in both interest income and interest expense was due primarily to the reduction in the mortgage investments and related borrowings.

During the year ended December 31, 2007, Belvedere Trust realized a loss of approximately $151.2 million on the sale of and impairment of its assets. During the year ended December 31, 2006, Belvedere Trust realized a

gain of approximately $2.6 million on the sale of $103 million in face amount of Belvedere Trust's other MBS, or BT Other MBS, as part of its asset/liability management program and were designed to reduce credit exposure.

Total expenses for discontinued operations were $4.5 million for the year ended December 31, 2007 compared to $3.4 million for the year ended December 31, 2006. The increase in expenses of approximately $1.1 million was due primarily to an increase in loan loss reserve expenses of approximately $0.9 million and the write-off of shelf registration costs (for the BellaVista shelf) of approximately $0.5 million.

Financial Condition

Agency MBS Portfolio

At December 31, 2008, we held agency mortgage assets whose amortized cost was approximately $5.26 billion, consisting primarily of $4.23 billion of adjustable-rate MBS, $1.03 billion of fixed-rate MBS and $8 million of floating-rate CMOs. This amount represents an approximate 14% increase from the $4.63 billion held at December 31, 2007. Of the adjustable-rate Agency MBS owned by us, 19% were adjustable-rate pass-through certificates whose coupons reset within one year. The remaining 81% consisted of hybrid adjustable-rate MBS whose coupons will reset between one year and five years. Hybrid adjustable-rate MBS have an initial interest rate that is fixed for a certain period, usually three to five years, and thereafter adjust annually for the remainder of the term of the loan.

The following table presents a schedule of our Agency MBS at fair value owned at December 31, 2008 and December 31, 2007, classified by type of issuer (dollar amounts in thousands):

                                December 31, 2008            December 31, 2007
                                Fair       Portfolio         Fair       Portfolio
       Agency                   Value      Percentage        Value      Percentage
       Fannie Mae (FNM)      $ 3,971,748         74.8 %   $ 3,412,030         73.2 %
       Freddie Mac (FHLMC)     1,309,149         24.7       1,215,291         26.1
       Ginnie Mae (GNMA)          26,543          0.5          35,226          0.7

       Total Agency MBS:     $ 5,307,440          100 %   $ 4,662,547          100 %

The following table classifies our portfolio of Agency MBS owned at December 31, 2008 and December 31, 2007, by type of interest rate index (dollar amounts in thousands):

                                             December 31, 2008                December 31, 2007
                                            Fair         Portfolio           Fair         Portfolio
Agency                                      Value        Percentage          Value        Percentage
One-month LIBOR                          $     7,669            0.2 %     $     9,369            0.2 %
Six-month LIBOR                               43,192            0.8            52,366            1.1
One-year LIBOR                             3,690,221           69.5         3,203,408           68.7
Six-month certificate of deposit               1,653            0.1             2,101            0.1
Six-month constant maturity treasury             671             -                766             -
One-year constant maturity treasury          478,422            9.0           530,614           11.4
Cost of Funds Index                           38,972            0.7            44,516            0.9
Fixed-rate                                 1,046,640           19.7           819,407           17.6

Total Agency MBS:                        $ 5,307,440            100 %     $ 4,662,547            100 %

The fair values indicated do not include interest earned but not yet paid. With respect to our hybrid adjustable-rate MBS, 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. The fair value of our Agency MBS is reported to us independently from dealers who are major financial institutions and are considered to be market makers for these types of instruments.

At December 31, 2008, our total Agency MBS portfolio had a weighted average coupon of 5.54%. The average coupon of the adjustable-rate securities was 5.19%, the hybrid securities average coupon was 5.56%, the fixed-rate securities average coupon was 5.79% and the CMO floaters average coupon was 2.01%. At December 31, 2007, our total Agency MBS portfolio had a weighted average coupon of 5.91%. The average coupon of the adjustable-rate securities was 6.10%, the hybrid securities average coupon was 5.85%, the fixed-rate securities average coupon was 5.92% and the CMO floaters average coupon was 5.84%.

. . .