================================================================================UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON,Washington, D.C. 20549FORM 10-Q
X QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES - ----- EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED: SEPTEMBER 30, 2003 OR TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES - ----- EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM ____________ TO ______________ COMMISSION FILE NUMBER:
þ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended: March 31, 2004 OR o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _______________ to ______________ Commission File Number: 1-8996
CAPSTEAD MORTGAGE CORPORATION
(Exact(Exact name of Registrant as specified in its Charter)MARYLAND 75-2027937 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 8401 NORTH CENTRAL EXPRESSWAY, SUITE 800, DALLAS, TX 75225 (Address of principal executive offices) (Zip Code) Registrant's
Maryland
(State or other jurisdiction of
incorporation or organization)75-2027937
(I.R.S. Employer
Identification No.)
8401 North Central Expressway, Suite 800, Dallas, TX
(Address of principal executive offices)75225
(Zip Code)Registrant’s telephone number, including area code:(214) 874-2323
Indicate by check mark whether the Registrant (1) has filed all documents and reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES
Xþ NO----- -----oIndicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). YES
Xþ NO----- ------oAPPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the
issuer'sissuer’s classes of common stock, as of the last practicable date.Common Stock ($0.01 par value) 14,016,803 as of November 5, 2003 ================================================================================
Common Stock ($0.01 par value) 14,854,952 as of April 30, 2004 CAPSTEAD MORTGAGE CORPORATION
FORM 10-Q
FOR THE QUARTER ENDEDSEPTEMBER 30, 2003MARCH 31, 2004INDEX
PART I. -- FINANCIAL INFORMATION
PAGE ----Page 3 4 5 6 15 31 31 31 32 32 Computation of Ratio Of Earnings Certification Pursuant to Section 302 Certification Pursuant to Section 302 Certification Pursuant to Section 906 -2-
PART I. — FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
PART I. -- FINANCIAL INFORMATIONCAPSTEAD MORTGAGE CORPORATION
CONSOLIDATED BALANCE SHEETS(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
SEPTEMBER 30, 2003 DECEMBER 31, 2002 ------------------ ----------------- (UNAUDITED)ASSETS Mortgage securities and similar investments ($2.0 billion pledged under repurchase arrangements) $ 2,120,974 $ 2,431,519 CMO collateral and investments 240,528 1,083,421 -------------- -------------- 2,361,502 3,514,940 Real estate held for lease, net of accumulated depreciation 134,341 137,122 Receivables and other assets 58,474 55,863 Cash and cash equivalents 98,025 59,003 -------------- -------------- $ 2,652,342 $ 3,766,928 ============== ============== LIABILITIES Repurchase arrangements and similar borrowings $ 1,994,389 $ 2,145,656 Collateralized mortgage obligations ("CMOs") 239,565 1,074,779 Borrowings secured by real estate 120,253 120,400 Incentive fee payable to former affiliate -- 4,982 Common stock dividend payable 10,513 116,585 Accounts payable and accrued expenses 5,281 5,948 -------------- -------------- 2,370,001 3,468,350 -------------- -------------- STOCKHOLDERS' EQUITY Preferred stock - $0.10 par value; 100,000 shares authorized: $1.60 Cumulative Preferred Stock, Series A, 211 and 219 shares issued and outstanding at September 30, 2003 and December 31, 2002, respectively ($3,468 aggregate liquidation preference) 2,956 3,058 $1.26 Cumulative Convertible Preferred Stock, Series B, 15,819 and 15,820 shares issued and outstanding at September 30, 2003 and December 31, 2002, respectively ($180,025 aggregate liquidation preference) 176,707 176,708 Common stock - $0.01 par value; 100,000 shares authorized; 14,017 and 13,962 shares issued and outstanding at September 30, 2003 and December 31, 2002, respectively 140 140 Paid-in capital 456,981 458,919 Accumulated deficit (387,718) (387,718) Accumulated other comprehensive income 33,275 47,471 -------------- -------------- 282,341 298,578 -------------- -------------- $ 2,652,342 $ 3,766,928 ============== ==============
(In thousands, except per share amounts)
March 31, 2004 December 31, 2003 (unaudited) (NOTE 2) Mortgage securities and similar investments ($2.2 billion pledged under repurchase arrangements in 2004) $ 2,415,164 $ 2,195,117 CMO collateral and investments 129,302 167,571
2,544,466 2,362,688 Real estate held for lease, net of accumulated depreciation 132,487 133,414 Receivables and other assets 41,814 41,880 Cash and cash equivalents 2,896 16,340
$ 2,721,663 $ 2,554,322
Repurchase arrangements and similar borrowings $ 2,168,419 $ 1,975,178 Collateralized mortgage obligations (“CMOs”) 128,629 166,807 Borrowings secured by real estate 120,154 120,206 Common stock dividend payable 7,807 8,829 Accounts payable and accrued expenses 3,736 6,264
2,428,745 2,277,284
Preferred stock — $0.10 par value; 100,000 shares authorized: $1.60 Cumulative Preferred Stock, Series A, 209 and 211 shares issued and outstanding at March 31, 2004 and December 31, 2003, respectively ($3,435 aggregate liquidation preference) 2,928 2,956 $1.26 Cumulative Convertible Preferred Stock, Series B, 15,819 shares issued and outstanding at March 31, 2004 and December 31, 2003 ($180,025 aggregate liquidation preference) 176,707 176,707 Common stock — $0.01 par value; 100,000 shares authorized; 14,837 and 14,015 shares issued and outstanding at March 31, 2004 and December 31, 2003, respectively 148 140 Paid-in capital 469,605 456,198 Accumulated deficit (387,718 ) (387,718 ) Accumulated other comprehensive income 31,248 28,755
292,918 277,038
$ 2,721,663 $ 2,554,322
See accompanying notes to consolidated financial statements.
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CAPSTEAD MORTGAGE CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) (UNAUDITED)
QUARTER ENDED NINE MONTHS ENDED SEPTEMBER 30 SEPTEMBER 30 ---------------------------- ---------------------------- 2003 2002 2003 2002 ------------ ------------ ------------ ------------INTEREST INCOME: Mortgage securities and similar investments $ 19,599 $ 34,866 $ 66,384 $ 120,701 CMO collateral and investments 5,971 26,316 31,061 94,446 ------------ ------------ ------------ ------------ Total interest income 25,570 61,182 97,445 215,147 ------------ ------------ ------------ ------------ INTEREST AND RELATED EXPENSE: Repurchase arrangements and similar borrowings 5,377 11,886 19,050 38,897 CMO borrowings 5,803 26,594 31,152 95,559 Mortgage insurance and other 93 144 301 468 ------------ ------------ ------------ ------------ Total interest and related expense 11,273 38,624 50,503 134,924 ------------ ------------ ------------ ------------ Net margin on financial assets 14,297 22,558 46,942 80,223 ------------ ------------ ------------ ------------ REAL ESTATE LEASE INCOME 2,468 3,219 7,564 5,406 ------------ ------------ ------------ ------------ REAL ESTATE-RELATED EXPENSE: Interest 1,046 1,918 3,271 3,214 Depreciation 927 962 2,781 1,604 ------------ ------------ ------------ ------------ Total real estate-related expense 1,973 2,880 6,052 4,818 ------------ ------------ ------------ ------------ Net margin on real estate held for lease 495 339 1,512 588 ------------ ------------ ------------ ------------ OTHER REVENUE (EXPENSE): Gain on asset sales and CMO redemptions 1,411 1,901 4,551 1,901 CMO administration and other 459 914 860 2,114 Incentive fee payable to former affiliate -- (1,351) (500) (4,034) Other operating expense (1,883) (1,610) (5,802) (5,080) ------------ ------------ ------------ ------------ Total other revenue (expense) (13) (146) (891) (5,099) ------------ ------------ ------------ ------------ $ 14,779 $ 22,751 $ 47,563 $ 75,712 ============ ============ ============ ============ NET INCOME Net income $ 14,779 $ 22,751 $ 47,563 $ 75,712 Less cash dividends paid on preferred stock (5,068) (5,097) (15,204) (15,296) ------------ ------------ ------------ ------------ Net income available to common stockholders $ 9,711 $ 17,654 $ 32,359 $ 60,416 ============ ============ ============ ============ NET INCOME PER COMMON SHARE: Basic $ 0.69 $ 1.27 $ 2.32 $ 4.36 Diluted 0.63 1.15 2.04 3.82 CASH DIVIDENDS DECLARED PER SHARE: Common $ 0.750 $ 1.320 $ 2.470 $ 4.440 Series A Preferred 0.400 0.400 1.200 1.200 Series B Preferred 0.315 0.315 0.945 0.945
(In thousands, except per share amounts)
(Unaudited)
Quarter Ended March 31 2004 2003 Mortgage securities and similar investments $ 19,437 $ 25,137 CMO collateral and investments 2,506 14,968
Total interest income 21,943 40,105
Repurchase arrangements and similar borrowings 5,830 7,219 CMO borrowings 2,293 15,339 Mortgage insurance and other 47 109
Total interest and related expense 8,170 22,667
Net margin on financial assets 13,773 17,438
2,525 2,521
Interest 1,085 1,092 Depreciation 927 927
Total real estate-related expense 2,012 2,019
Net margin on real estate held for lease 513 502
Gain on asset sales and CMO redemptions — 1,748 CMO administration and other 67 220 Incentive fee payable to former affiliate — (303 ) Other operating expense (1,999 ) (2,062 )
Total other revenue (expense) (1,932 ) (397 )
$ 12,354 $ 17,543
Net income $ 12,354 $ 17,543 Less cash dividends on preferred shares (5,067 ) (5,070 )
Net income available to common stockholders $ 7,287 $ 12,473
Basic $ 0.51 $ 0.90 Diluted 0.50 0.75 Common $ 0.530 $ 0.940 Series A Preferred 0.400 0.400 Series B Preferred 0.315 0.315 See accompanying notes to consolidated financial statements.
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CAPSTEAD MORTGAGE CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS(IN THOUSANDS) (UNAUDITED)
NINE MONTHS ENDED SEPTEMBER 30 -------------------------------- 2003 2002 -------------- --------------OPERATING ACTIVITIES: Net income $ 47,563 $ 75,712 Noncash items: Amortization of discount and premium 9,185 17,699 Depreciation and other amortization 3,740 2,692 Recognition of rent abatement 58 (3,172) Gain on asset sales and CMO redemptions (4,551) (1,901) Net change in prepaids, receivables, other assets, accounts payable and accrued expenses (7,388) (16,310) -------------- -------------- Net cash provided by operating activities 48,607 74,720 -------------- -------------- INVESTING ACTIVITIES: Purchases of mortgage securities and similar investments (235,028) (104,228) Purchase of real estate -- (23,320) Principal collections on mortgage securities and similar investments 645,199 863,506 Proceeds from asset sales 123,543 16,901 CMO collateral: Principal collections 594,113 794,826 Decrease in accrued interest receivable 3,382 4,801 -------------- -------------- Net cash provided by investing activities 1,131,209 1,552,486 -------------- -------------- FINANCING ACTIVITIES: Decrease in repurchase arrangements and similar borrowings (151,267) (830,941) Decrease in borrowings secured by real estate (147) (393) CMO borrowings: Principal payments on securities (829,111) (798,286) Decrease in accrued interest payable (4,487) (4,458) Capital stock transactions 70 190 Dividends paid (155,852) (58,105) -------------- -------------- Net cash used in financing activities (1,140,794) (1,691,993) -------------- -------------- Net change in cash and cash equivalents 39,022 (64,787) Cash and cash equivalents at beginning of period 59,003 123,520 -------------- -------------- Cash and cash equivalents at end of period $ 98,025 $ 58,733 ============== ==============
(In thousands)
(Unaudited)
Quarter Ended March 31 2004 2003 Net income $ 12,354 $ 17,543 Noncash items: Amortization of discount and premium 2,009 5,999 Depreciation and other amortization 1,117 1,254 Recognition of rent abatement 43 (27 ) Gain on asset sales and CMO redemptions — (1,748 ) Change in incentive fee payable to former affiliate — (5,080 ) Net change in receivables, other assets, accounts payable and accrued expenses (1,700 ) 251
Net cash provided by operating activities 13,823 18,192
Purchases of mortgage securities and similar investments (368,700 ) (28,540 ) Principal collections on mortgage securities and similar investments 148,054 216,479 Proceeds from asset sales — 34,329 CMO collateral: Principal collections 37,757 260,328 Decrease in accrued interest receivable 233 1,732
Net cash provided by (used in) investing activities (182,656 ) 484,328
Net increase (decrease) in repurchase arrangements and similar borrowings 193,241 (66,530 ) Principal payments on borrowings secured by real estate (52 ) (52 ) CMO borrowings: Principal payments on securities (37,563 ) (297,039 ) Decrease in accrued interest payable (218 ) (1,564 ) Capital stock transactions 13,877 (2 ) Dividends paid (13,896 ) (121,655 )
Net cash provided by (used in) financing activities 155,389 (486,842 )
Net change in cash and cash equivalents (13,444 ) 15,678 Cash and cash equivalents at beginning of period 16,340 59,003
Cash and cash equivalents at end of period $ 2,896 $ 74,681
See accompanying notes to consolidated financial statements.
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CAPSTEAD MORTGAGE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTSSEPTEMBER 30, 2003 (UNAUDITED)
MARCH 31, 2004
(Unaudited)NOTE 1
--— BUSINESSCapstead Mortgage Corporation
("Capstead"(together with its subsidiaries, “Capstead” or the"Company"“Company”) operates as a real estate investment trust("REIT"(“REIT”) earning income from investing in real estate-related assets on a leveraged basis and from other investment strategies. These investmentscurrently include,primarily consist of, but are not limited to,single-familyfinancial assets, specifically residential adjustable-rate mortgage("ARM"(“ARM”) securities issued by government-sponsored entities, either Fannie Mae, Freddie Mac or Ginnie Mae("(“AgencySecurities"Securities”). Capstead has also made limited investments in credit-sensitive commercial real estate-related assets, including the direct ownership of real estate. Management believes that such investments, when available at favorable prices and combined with the prudent use of leverage, can produce attractive risk-adjusted returns over the long term withlessrelatively low sensitivity to changes in interest rates.The earning capacity of Capstead’s financial asset portfolios is influenced by the overall size and composition of the portfolios, the relationship between short- and long-term interest rates
due largely(the “yield curve”) and the extent the Company continues to invest its liquidity in these portfolios. Although the Company has had success in recent quarters acquiring ARM securities at relatively attractive prices and runoff caused by mortgage prepayments has moderated considerably during the first quarter of 2004, runoff remains ahigher risk of default and reduced liquidity comparedchallenge tofixed-rate and medium-term Agency Securities. Capstead's investment portfolios declinedearnings generated by these portfolios. To thelast several years primarily because of high levelsextent the proceeds of mortgage prepayments anda lack of suitable investment opportunities at favorable prices. Consequently, in 2001 and again in January 2003 (with the payment of the fourth quarter 2002 common dividend), Capstead returned a significant portion of its equity capital to its common stockholders. To the extent proceeds of runoff or asset salesother maturities are not reinvested or cannot be reinvested at a rate of return on invested capital at least equal to therate previouslyreturn earned onthat capital, quarterlyprevious investments, earnings and common dividends maycontinue trending lower. The future size and composition of Capstead's investment portfolios will depend on market conditions, including levels of mortgage prepayments and the availability on a timely basis of suitable investments at favorable prices.decline.NOTE 2
--— BASIS OF PRESENTATIONINTERIM FINANCIAL REPORTINGInterim Financial Reporting
The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States
("GAAP"(“GAAP”) for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the quarterand nine monthsendedSeptember 30, 2003March 31, 2004 are not necessarily indicative of the results that may be expected for the calendar year ending December 31,2003.2004. For further information refer to the consolidated financial statements and footnotes theretoincludedincorporated by reference in theCompany'sCompany’s annual report on Form 10-K for the year ended December 31,2002. STOCK-BASED COMPENSATION2003.Stock-Based Compensation
The Company accounts for stock-based awards for employees and directors under the recognition and measurement principles of the Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related Interpretations (“APB25”). Under APB25 compensation cost for stock-based awards for employees and directors is measured as the excess, if any, of the quoted market price of the
Company'sCompany’s stock at the date of the grant over the amount to be paid to acquire the stock and is recognized inOther operating expenseas the awards vest and restrictions lapse(the "APB25 intrinsic value method"). Ifon a straight-line basis. The increase in total stock-based compensation expense if determined under thealternativefairvaluevalue-based methodologyincluded inprescribed under Statement of Financial Accounting Standards No. 123"Accounting“Accounting for-6-
Stock-based
Compensation" were followed, reported net incomeCompensation” (“SFAS 123”) would have beenlower byless than$25,000 per quarter, representing a zero to one cent impact$15,000 for the three months ended March 31, 2004 and 2003, respectively, which would have had no effect on reported net income per common share for the periods presented.-6-RECLASSIFICATIONS Certain prior period amounts have been reclassified to conform to the current period presentation.NOTE 3
--— NET INCOME PER COMMON SHAREBasic net income per common share is computed by dividing net income, after deducting preferred share dividends, by the weighted average number of common shares outstanding. Diluted net income per common share is computed by dividing net income, after deducting preferred share dividends for antidilutive convertible preferred shares,
if any,by the weighted average number of common shares and common share equivalents outstanding, giving effect to dilutive stock options and dilutive convertible preferred shares.For dilutive net income per share purposes, the Series A and B preferred shares are considered dilutive whenever annualized basic net income per share exceeds each Series' annualized dividend divided by the conversion rate applicable for that period.The components of the computation of basic and diluted net income per share were as follows (in thousands, except per share data):
QUARTER ENDED NINE MONTHS ENDED SEPTEMBER 30 SEPTEMBER 30 -------------------------- -------------------------- 2003 2002 2003 2002 ----------- ----------- ----------- -----------NUMERATOR FOR BASIC NET INCOME PER COMMON SHARE: Net income $ 14,779 $ 22,751 $ 47,563 $ 75,712 Less all preferred share dividends (5,068) (5,097) (15,204) (15,296) ----------- ----------- ----------- ----------- Net income available to common stockholders $ 9,711 $ 17,654 $ 32,359 $ 60,416 =========== =========== =========== =========== WEIGHTED AVERAGE COMMON SHARES OUTSTANDING 13,995 13,871 13,969 13,850 BASIC NET INCOME PER COMMON SHARE $ 0.69 $ 1.27 $ 2.32 $ 4.36 NUMERATOR FOR DILUTED NET INCOME PER COMMON SHARE: Net income $ 14,779 $ 22,751 $ 47,563 $ 75,712 =========== =========== =========== =========== DENOMINATOR FOR DILUTED NET INCOME PER COMMON SHARE: Weighted average common shares outstanding 13,995 13,871 13,969 13,850 Net effect of dilutive stock options 38 50 35 59 Net effect of dilutive preferred shares * 9,302 5,898 9,263 5,901 ----------- ----------- ----------- ----------- 23,335 19,819 23,267 19,810 =========== =========== =========== =========== DILUTED NET INCOME PER COMMON SHARE $ 0.63 $ 1.15 $ 2.04 $ 3.82* The increase in net effect of dilutive preferred shares reflects, on a weighted average basis, changes in preferred share conversion rates resulting from the payment of common dividends in excess of net income available to common stockholders. Current conversion rates are 1.4818 common shares for each Preferred A share and 0.5708 common shares for each Preferred B share converted. It remains uneconomical to convert the Series B preferred shares at current market prices of the common and Series B preferred shares.
Quarter Ended March 31 2004 2003 Net income $ 12,354 $ 17,543 Less all preferred share dividends (5,067 ) (5,070 )
Net income available to common stockholders $ 7,287 $ 12,473
14,267 13,935
$ 0.51 $ 0.90
Net income $ 12,354 $ 17,543 Less dividends on Series B preferred shares (4,983 ) —
$ 7,371 $ 17,543
Weighted average common shares outstanding 14,267 13,935 Net effect of dilutive stock options 39 90 Net effect of dilutive preferred shares: Series A 314 317 Series B — 8,910
14,620 23,252
$ 0.50 $ 0.75
NOTE 4
--— MORTGAGE SECURITIES AND SIMILAR INVESTMENTSThe Company classifies its mortgage securities and similar investments by collateral type and interest rate characteristics. Agency Securities are AAA-rated and are considered to have limited credit risk. Non-agency securities consist of private mortgage pass-through securities originally formed prior to 1995 when the Company operated a mortgage conduit. These securities are backed
primarilybysingle-familyresidential mortgage loans whereby the related credit risk of the underlying loans is either borne by AAA-rated private mortgage insurers or by the Company("(“Non-agencySecurities"Securities”). Included inReceivables and other assetsas restricted cash at March 31, 2004 are $6.0 million in related special hazard (e.g. earthquake or mudslide-related losses) and bankruptcy reserve funds. Commercial mortgage securitizations generally have senior, mezzanine and subordinate classes of bonds with the lower bond classes providing credit enhancement to the more senior classes. Commercial mortgage-backed securities("CMBS"(“CMBS”) held by the Company as ofSeptember 30, 2003March 31, 2004 are mezzanine classes and therefore carry credit risk associated with the underlying pools of commercial mortgage loans that is mitigated by-7-subordinate bonds held by other investors. Commercial loans held by the Company as of September 30, 2003 consist of a loan to a joint venture that holds commercial real estate.The maturity of mortgage securities is directly affected by the rate of principal prepayments on the underlying loans.-7-
Fixed-rate investments have fixed rates of interest and initial expected weighted average lives of greater than five years. Adjustable-rate investments have interest rates that adjust at least annually to more current interest rates. For instance, mortgage loans underlying ARM securities either (i) adjust annually based on a specified margin over the one-year Constant Maturity U.S. Treasury Note Rate
("(“One-yearCMT"CMT”), (ii) adjust semiannually based on a specified margin over the six-month London Interbank Offered Rate("LIBOR"(“LIBOR”), or (iii) adjust monthly based on a specific margin over an index such as LIBOR or the Cost of Funds Index as published by the Eleventh District Federal Reserve Bank("COFI"(“COFI”). In addition, the terms of most ARM loans limit, subject to periodic and lifetime limits on the amount of such adjustments during any single interest rate adjustment period and over the life of the loan. CMBSand commercial loansheld as ofSeptember 30, 2003March 31, 2004 adjust monthly based on a specified margin over 30-day LIBOR. Mortgage securities and similar investments and the related average effective interest rates were as follows (dollars in thousands):
Average Principal Premiums Carrying Coupon Average Balance (Discounts) Basis Amount (a) Rate (b) Yield (b) Agency Securities: Fannie Mae/Freddie Mac: Fixed-rate $ 54,932 $ 151 $ 55,083 $ 55,157 6.65 % 9.79 % LIBOR/CMT ARMs 1,192,839 20,054 1,212,893 1,231,416 3.57 3.16 COFI ARMs 84,744 (2,451 ) 82,293 85,742 3.48 4.36 Ginnie Mae ARMs 830,939 8,775 839,714 847,428 4.17 3.43
2,163,454 26,529 2,189,983 2,219,743 3.88 3.33
Non-agency Securities: Fixed-rate 48,638 69 48,707 48,791 6.77 6.15 LIBOR/CMT ARMs 71,464 1,057 72,521 73,411 4.01 3.07
120,102 1,126 121,228 122,202 5.13 4.88 73,219 (3 ) 73,216 73,219 2.14 2.19
$ 2,356,775 $ 27,652 $ 2,384,427 $ 2,415,164 3.89 3.42
Agency Securities: Fannie Mae/Freddie Mac: Fixed-rate $ 2,072 $ 12 $ 2,084 $ 2,160 10.00 % 9.38 % LIBOR/CMT ARMs 1,050,761 15,626 1,066,387 1,084,492 3.67 3.60 COFI ARMs 90,669 (2,623 ) 88,046 91,566 3.57 4.84 Ginnie Mae ARMs 726,876 7,830 734,706 739,987 4.27 4.10
1,870,378 20,845 1,891,223 1,918,205 3.90 3.88
Non-agency Securities: Fixed-rate 118,638 174 118,812 118,812 6.66 6.25 LIBOR/CMT ARMs 81,425 1,293 82,718 83,724 4.42 3.64
200,063 1,467 201,530 202,536 5.75 4.63 74,376 (9 ) 74,367 74,376 2.21 2.83 Commercial loans — — — — — 8.40
$ 2,144,817 $ 22,303 $ 2,167,120 $ 2,195,117 4.02 3.97
AVERAGE PRINCIPAL PREMIUMS CARRYING COUPON AVERAGE BALANCE (DISCOUNTS) BASIS AMOUNT(a) RATEIncludes unrealized gains and losses for securities classified as available-for-sale, if applicable (see NOTE 10). (b) YIELD (b) ----------- ----------- ----------- ------------ ---------- -----------SEPTEMBER 30, 2003 Agency Securities: Fannie Mae/Freddie Mac: Fixed-rate $ 2,350 $ 14 $ 2,364 $ 2,459 10.00% 9.41% LIBOR/CMT ARMs 937,543 13,416 950,959 970,609 3.92 3.43 COFI ARMs 99,528 (2,878) 96,650 100,576 3.71 4.83 Ginnie Mae ARMs 706,595 7,639 714,234 721,676 4.58 3.85 ----------- ----------- ----------- ----------- 1,746,016 18,191 1,764,207 1,795,320 4.18 3.69 Non-agency Securities: Fixed-rate 122,394 429 122,823 122,908 6.64 6.47 LIBOR/CMT ARMs 92,028 1,538 93,566 94,669 4.76 3.00 ----------- ----------- ----------- ----------- 214,422 1,967 216,389 217,577 5.82 4.68 CMBS (c) 72,587 (20) 72,567 72,587 2.17 2.21 Commercial loans (c) 35,469 21 35,490 35,490 8.50 8.45 ----------- ----------- ----------- ----------- $ 2,068,494 $ 20,159 $ 2,088,653 $ 2,120,974 4.35 3.82 =========== =========== =========== =========== DECEMBER 31, 2002 Agency Securities: Fannie Mae/Freddie Mac: Fixed-rate $ 3,628 $ 21 $ 3,649 $ 3,788 10.00% 9.48% LIBOR/CMT ARMs 1,120,142 16,376 1,136,518 1,162,197 4.99 5.04 COFI ARMs 126,356 (3,655) 122,701 128,475 4.20 5.30 Ginnie Mae ARMs 881,911 9,767 891,678 904,470 5.36 5.25 ----------- ----------- ----------- ----------- 2,132,037 22,509 2,154,546 2,198,930 5.10 5.16Average Coupon Rate is presented net of servicing and other fees as of the indicated balance sheet date. Average Effective Rate is presented for the quarter then ended, calculated including the amortization of premiums and discounts, mortgage insurance costs on Non-agency Securities and excluding unrealized gains and losses. (c) 83,073 713 83,786 85,290 5.12 5.62 CMBS (c) 107,989 (309) 107,680 107,762 3.04 3.96 Commercial loans (c) 39,505 32 39,537 39,537 8.50 9.03 ----------- ----------- ----------- ----------- $ 2,362,604 $ 22,945 $ 2,385,549 $ 2,431,519 5.07 5.17 =========== =========== =========== ===========As of the indicated dates, these portfolios consisted nearly exclusively of adjustable-rate investments. (a) Includes mark-to-market for securities classified as available-for-sale, if applicable (see NOTE 10). (b) Average Coupon Rate is presented as of the indicated balance sheet date. Average Yield is presented for the quarter then ended, calculated including amortization of premiums (discounts), mortgage insurance costs on Non-agency Securities and excluding unrealized gains and losses. (c) As of the indicated dates, these portfolios consisted nearly exclusively of adjustable-rate investments.-8-
In connection with the formation of private mortgage pass-through securities prior to 1995, the Company was required to establish reserve funds available to pay special hazard (e.g. earthquake or mudslide-related losses) or certain bankruptcy costs. The private mortgage pass-through securities were subsequently held as Non-agency Securities, pledged as CMO collateral or sold to third parties. As of September 30, 2003, included in Receivables and other assets as restricted cash are $4.9 million in special hazard reserve funds and $1.2 million of bankruptcy reserve funds associated with $55 million and $57 million of loans outstanding, respectively.NOTE 5
--—CMO COLLATERAL AND INVESTMENTSCMO collateral consists of
primarily fixed-rate mortgage securities collateralized by single-family residential mortgage loansNon-Agency Securities and relatedshort-term investments, bothaccrued interest, all pledged to secure CMO borrowings("(“Pledged CMOCollateral"Collateral”). All principal and interest on pledged mortgage securities is remitted directly to collection accounts maintained by atrustee. Thetrusteeis responsible for reinvesting those funds in short-term investments. All collections on the pledged mortgage securitiesandthe reinvestment income earned thereon areis available for the payment of principal and interest on CMO borrowings. The components of CMO collateral and investments were as follows (in thousands):
SEPTEMBER 30, 2003 DECEMBER 31, 2002 ------------------ -----------------Pledged CMO Collateral: Pledged mortgage securities $ 237,269 $1,066,734 Accrued interest receivable 1,515 6,325 ---------- ---------- 238,784 1,073,059 Unamortized premium 1,744 8,571 ---------- ---------- 240,528 1,081,630 CMO investments -- 1,791 ---------- ---------- $ 240,528 $1,083,421 ========== ==========
March 31, 2004 December 31, 2003 Pledged CMO Collateral: Pledged mortgage securities $ 127,066 $ 164,891 Accrued interest receivable 851 1,085
127,917 165,976 Unamortized premium 1,385 1,595
$ 129,302 $ 167,571
Credit risk associated with Pledged
mortgage securities are private mortgage pass-through securities whereby the related credit risk of the underlying loansCMO Collateral is borne by AAA-rated private mortgage insurers or subordinated bonds within the related CMO series to which the collateral is pledged.With recent redemptions of previously-issued CMO series, the Company no longer has credit risk held in the form of subordinate bonds associated with Pledged CMO Collateral.The weighted average yield for Pledged CMO Collateral and investments was5.99%6.69% during the quarter endedSeptember 30, 2003.March 31, 2004.NOTE 6
--—REAL ESTATE HELD FOR LEASEIn May 2002 Capstead acquired six
"independent"“independent” senior living facilities (wherein the operator of the facility provides most of the tenants little, if any, medical care)(the "Properties"(collectively, the “Properties”). The aggregate purchase price of the Properties was $139.7 million including approximately $3.1 million in closing costs and the assumption by Capstead of $19.7 million of related mortgage debt and $101.1 million of tax-exempt bond debt.The Properties were acquired pursuant to purchase agreements initially negotiated and executed by an affiliate of Brookdale Living Communities, Inc. (collectively with its subsidiaries, “Brookdale”) and subsequently assigned to Capstead. Concurrent with the acquisition, the Company entered into a long-term
"net-lease"“net-lease” arrangement with Brookdale,Living Communities, Inc. (collectively with its subsidiaries, "Brookdale"),under which Brookdale is responsible for the ongoing operation and management of the Properties. Brookdale, an owner, operator, developer and manager of senior living facilities, is a majority-owned affiliate of Fortress Investment Group, LLC which, together with its affiliates, is referred to as Fortress (see NOTE14)12).The
net-leaselease arrangementwith Brookdaleconsists of a master lease covering all of the Properties and individual property-level leases (referred to collectively as the"Lease"“Lease”). The Lease has an initial term of 20 years and provides for two 10-year renewal periods. BeginninginMay 1, 2007, Brookdale will have the option of purchasing all of the Properties from Capstead at the greater of fair value orCapstead'sCapstead’s original cost, after certain adjustments.Under the terms of the Lease,After an initial three-month rent concession period, Brookdale is responsible for paying all expenses associated with the operation of the Properties, including real estate taxes, other governmental charges, insurance, utilities and maintenance, and an amount representing an attractive cash return on-9-Capstead'sCapstead’s equity in the Properties after payment of monthly debtservice.service subject to annual increases based upon increases (capped at 3%) in the Consumer Price Index. Because under the terms of the Lease, Brookdale is responsible for changes in related debt service requirements, earnings fromthe Company'sthis investmentin net-leased real estateare generally not affected by changes in interest rates. Included inReceivables and other assetsatSeptember 30,December 31, 2003 are$3.2$3.1 million in unamortized rent abatements and$1.5$1.2 million of other rent receivables due from Brookdale.-9-
The
componentsfollowing table summarizes carrying amounts ofreal estate held for lease were as followsthe Properties (in thousands):
SEPTEMBER 30, 2003 DECEMBER 31, 2002 ------------------ -----------------Land $ 16,450 $ 16,450 Buildings 119,550 119,550 Equipment and fixtures 3,600 3,600 --------- --------- 139,600 139,600 Accumulated depreciation (5,259) (2,478) --------- --------- $ 134,341 $ 137,122 ========= =========
March 31, 2004 December 31, 2003 Land $ 16,450 $ 16,450 Buildings 119,550 119,550 Equipment and fixtures 3,600 3,600
139,600 139,600 Accumulated depreciation (7,113 ) (6,186 )
$ 132,487 $ 133,414
NOTE 7
--— REPURCHASE ARRANGEMENTS AND SIMILAR BORROWINGSRepurchase arrangements and similar borrowings, classified by type of collateral, maturities and related weighted average interest rates for the dates indicated, were as follows (dollars in thousands):
SEPTEMBER 30, 2003 DECEMBER 31, 2002 ---------------------------- ----------------------------- BORROWINGS AVERAGE BORROWINGS AVERAGE OUTSTANDING RATE OUTSTANDING RATE --------------- --------- ------------- -----------Repurchase arrangements: Agency Securities (less than 31 days) $1,721,332 1.00% $1,980,050 1.34% Non-agency Securities (less than 31 days) 178,548 1.52 37,677 1.47 CMBS (31 to 90 days) 68,274 1.30 98,184 1.62 ---------- ---------- 1,968,154 1.06 2,115,911 1.36 Commercial bank borrowings 26,235 3.63 29,745 3.91 ---------- ---------- $1,994,389 1.09 $2,145,656 1.39 ========== ==========Borrowings madeCapstead borrows under uncommitted repurchase arrangements with only well-established investment banking
firmsfirms. Repurchase arrangements pursuant to which the Company pledges Agency and Non-agency Securities as collateral generally have maturities of less than 31 days.* Repurchase arrangements with CMBS pledged as collateral generally have longer initial maturities and may feature renewal options.Commercial bank borrowings at September 30, 2003 consist of an adjustable-rate loan that matures in January 2005 secured by a commercial loan investment.The terms and conditions of repurchase arrangements and similar borrowings are negotiated on a transaction-by-transaction basis.The weighted average effective interest rate on repurchaseRepurchase arrangements and similar borrowingswas 1.13% duringand related weighted average interest rates, classified by type of collateral and maturities, were as follows for thequarter ended September 30, 2003.dates indicated (dollars in thousands):
March 31, 2004 December 31, 2003 Borrowings Average Borrowings Average Outstanding Rate Outstanding Rate Repurchase arrangements: Agency Securities (less than 31 days) $ 2,003,717 1.06 % $ 1,735,027 1.09 % Non-agency Securities (less than 31 days) 95,834 1.43 170,205 1.57 CMBS (less than 31 days) 20,300 1.29 20,300 1.36 CMBS (greater than 90 days) 48,568 1.26 49,646 1.34
$ 2,168,419 1.09 $ 1,975,178 1.14
* Subsequent to quarter-end, the Company entered into several longer maturity repurchase arrangements totaling $200 million with maturities ranging from one and one-half to two years. NOTE 8
--— CMO BORROWINGSEach series of CMOs issued consists of various classes of bonds, most of which have fixed rates of interest. Interest is payable monthly at specified rates for all classes. The components of CMOs along with selected other information were as follows (dollars in thousands):
March 31, 2004 December 31, 2003 CMOs $ 126,632 $ 164,388 Accrued interest payable 720 938
Total obligation 127,352 165,326 Unamortized premium 1,277 1,481
$ 128,629 $ 166,807
Range of average interest rates 1.45% to 9.45% 1.50% to 9.42% Range of stated maturities 2025 to 2030 2025 to 2030 Number of series 6 6 -10-
Typically, principal payments on each series are made to each class in the order of their stated maturities so that no payment of principal is made on any class of bonds until all classes having an earlier stated maturity have been paid in full. The maturity of each CMO series is directly affected by the rate of principal prepayments on the related Pledged CMO Collateral. Each series is also subject to redemption provided that certain requirements specified in the related indenture have been met (referred to as
"Clean-up Calls"“Clean-up Calls”); therefore, the actual maturity of any series is likely to occur earlier than its stated maturity. The weighted average effective interest rate for all CMOs was5.62%6.12% during the quarter endedSeptember 30, 2003. -10-The components of CMOs along with selected other information were as follows (dollars in thousands):March 31, 2004.
SEPTEMBER 30, 2003 DECEMBER 31, 2002 ------------------ -----------------CMOs $ 236,525 $1,064,295 Accrued interest payable 1,298 5,785 ---------- ---------- Total obligation 237,823 1,070,080 Unamortized premium 1,742 4,699 ---------- ---------- $ 239,565 $1,074,779 ========== ========== Range of average interest rates 1.48% to 9.43% 1.78% to 9.99% Range of stated maturities 2024 to 2030 2008 to 2030 Number of series 7 17NOTE 9
--— BORROWINGS SECURED BY REAL ESTATEThe components of borrowings secured by real estate and related weighted average interest rates (calculated including bond issue cost amortization) for the dates indicated were as follows (dollars in thousands):
SEPTEMBER 30, 2003 DECEMBER 31, 2002 ------------------------------ ------------------------------- BORROWINGS AVERAGE BORROWINGS AVERAGE OUTSTANDING RATE OUTSTANDING RATE ------------- ---------- -------------- -----------Mortgage borrowings $ 19,412 7.92% $ 19,559 7.92% Tax-exempt bonds 100,841 2.83 100,841 2.74 -------- -------- $120,253 3.65 $120,400 3.58 ======== ========
March 31, 2004 December 31, 2003 Borrowings Average Borrowings Average Outstanding Rate Outstanding Rate Mortgage borrowings $ 19,313 7.92 % $ 19,365 7.92 % Tax-exempt bonds 100,841 2.55 100,841 2.54
$ 120,154 3.41 $ 120,206 3.40
Mortgage borrowings consist of a fixed-rate mortgage secured by one senior living facility that matures in 2009. The tax-exempt bonds are credit-enhanced by Fannie Mae and secured by mortgages on the remaining five senior living facilities. Interest rates on the bonds adjust weekly based on the Bond Market Association Municipal Swap Index
("(“BMAIndex"Index”). Interest rate cap agreements with notional amounts aggregating $100.8 million, five-year terms and cap rates equal to a 6% BMA Index are held to provide funds to pay interest on the bonds in excess of a 6% BMA Index, should that occur. The interest rate cap agreements were valued at$403,000$190,000 atSeptember 30, 2003March 31, 2004 and included inReceivables and other assets.Monthly principal and interest rate cap reserve fund payments are made to the trustee for the eventual retirement of the bonds by 2032 and the purchase of new cap agreements in 2007.In connection with the issuance of
thenew tax-exempt bonds in November 2002, Capstead placed into escrow with the trustee reserves for repairs and replacements totaling$2.7$2.9 million. Duringthe nine months ended September 30,2003, the trustee released $1.5 million of these funds. Another$6.0$6.1 million is held by the trustee in connection with Capstead posting a $6.0 million letter of credit from a rated financial institution to collateralize certain of the bonds. These funds, along with$1.0$1.7 million of principal and interest rate cap reserve funds, are included inReceivables and other assetsas restricted cash. Also included inReceivables and other assetsare$3.3$3.1 million in bond issue costs.The weighted average effective interest rate for all borrowings secured by real estate (calculated including bond issue cost amortization) was
3.47%3.65% for the quarter endedSeptember 30, 2003. -11-March 31, 2004. NOTE 10
--— DISCLOSURES REGARDING FAIR VALUES OF DEBT SECURITIESEstimated fair values of debt securities
have beenwere determined using available market information and appropriate valuation methodologies; however, considerable judgment is required in interpreting market data to develop these estimates. In addition, fair values fluctuate on a daily basis. Accordingly, estimates presented herein are not necessarily indicative of the amounts that could be realized in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on estimated fair values. The fair value of Agency Securities, Non-agency Securities and CMBS-11-
were estimated using either (i) quoted market prices when available, including quotes made by lenders in connection with designating collateral for repurchase arrangements, or (ii) offer prices for similar assets or market positions. The fair value of Pledged CMO Collateral was based on projected cash flows, after payment on the related CMOs, determined using market discount rates and prepayment assumptions. The maturity of mortgage assets is directly affected by the rate of principal payments on the underlying mortgage loans and, for Pledged CMO Collateral, Clean-up Calls of the remaining CMOs outstanding.
Commercial loans and other investmentsInvestments not held in the form of debt or equity securities are excluded from these disclosures.The following tables summarize fair value disclosures for available-for-sale debt securities (in thousands):
GROSS GROSS COST UNREALIZED UNREALIZED FAIR BASIS GAINS LOSSES VALUE ---------- ---------- ---------- ----------AS OF SEPTEMBER 30, 2003 Agency Securities: Fixed-rate $ 1,023 $ 95 $ -- $ 1,118 ARMs 1,761,843 31,061 43 1,792,861 ---------- ---------- ---------- ---------- 1,762,866 31,156 43 1,793,979 Non-agency Securities: Fixed-rate 2,369 85 -- 2,454 ARMs 64,323 1,104 1 65,426 ---------- ---------- ---------- ---------- 66,692 1,189 1 67,880 CMBS 72,567 32 12 72,587 CMO collateral and investments 18,006 585 -- 18,591 ---------- ---------- ---------- ---------- $1,920,131 $ 32,962 $ 56 $1,953,037 ========== ========== ========== ========== AS OF DECEMBER 31, 2002 Agency Securities: Fixed-rate $ 1,505 $ 139 $ -- $ 1,644 ARMs 2,150,897 44,251 6 2,195,142 ---------- ---------- ---------- ---------- 2,152,402 44,390 6 2,196,786 Non-agency Securities: Fixed-rate -- -- -- -- ARMS 83,262 1,504 -- 84,766 ---------- ---------- ---------- ---------- 83,262 1,504 -- 84,766 CMBS 107,680 112 30 107,762 CMO collateral and investments 26,943 873 2 27,814 ---------- ---------- ---------- ---------- $2,370,287 $ 46,879 $ 38 $2,417,128 ========== ========== ========== ==========
Gross Gross Cost Unrealized Unrealized Fair Basis Gains Losses Value Agency Securities: Fixed-rate $ 800 $ 74 $ — $ 874 ARMs 2,134,900 30,021 335 2,164,586
2,135,700 30,095 335 2,165,460 Non-agency Securities: Fixed-rate 1,068 84 — 1,152 ARMs 52,488 894 4 53,378
53,556 978 4 54,530 CMBS 73,216 16 13 73,219 CMO collateral and investments 14,752 431 — 15,183
$ 2,277,224 $ 31,520 $ 352 $ 2,308,392
Agency Securities: Fixed-rate $ 827 $ 76 $ — $ 903 ARMs 1,889,139 27,159 253 1,916,045
1,889,966 27,235 253 1,916,948 Non-agency Securities 58,613 1,009 3 59,619 CMBS 74,367 24 15 74,376 CMO collateral and investments 16,440 499 — 16,939
$ 2,039,386 $ 28,767 $ 271 $ 2,067,882
Held-to-maturity debt securities consist of Pledged CMO Collateral and collateral released from the related CMO indentures pursuant to Clean-up Calls and held as Agency Securities and Non-agency Securities.
-12-Fair value disclosures for debt securities held-to-maturity were as follows (in thousands):
GROSS GROSS COST UNREALIZED UNREALIZED FAIR BASIS GAINS LOSSES VALUE ---------- ---------- ---------- ----------AS OF SEPTEMBER 30, 2003 Released CMO Collateral: Agency Securities $ 1,341 $ 121 $ -- $ 1,462 Non-agency Securities 149,697 3,749 293 153,153 Pledged CMO Collateral 221,937 293 43 222,187 ---------- ---------- ---------- ---------- $ 372,975 $ 4,163 $ 336 $ 376,802 ========== ========== ========== ========== AS OF DECEMBER 31, 2002 Released CMO Collateral: Agency Securities $ 2,144 $ 192 $ -- $ 2,336 Non-agency Securities 524 52 -- 576 Pledged CMO Collateral 1,055,607 795 4,639 1,051,763 ---------- ---------- ---------- ---------- $1,058,275 $ 1,039 $ 4,639 $1,054,675 ========== ========== ========== ==========
Gross Gross Cost Unrealized Unrealized Fair Basis Gains Losses Value Released CMO Collateral: Agency Securities — Fixed-rate $ 54,283 $ 2,944 $ — $ 57,227 Non-agency Securities: Fixed-rate 47,639 1,937 — 49,576 ARMs 20,033 109 268 19,874
121,955 4,990 268 126,677 Pledged CMO Collateral 114,119 190 — 114,309
$ 236,074 $ 5,180 $ 268 $ 240,986
-12-
Gross Gross Cost Unrealized Unrealized Fair Basis Gains Losses Value Released CMO Collateral: Agency Securities — Fixed-rate $ 1,257 $ 113 $ — $ 1,370 Non-agency Securities
Fixed-rate118,812 4,310 — 123,122 ARMs 24,105 135 365 23,875
144,174 4,558 365 148,367 Pledged CMO Collateral 150,632 224 — 150,856
$ 294,806 $ 4,782 $ 365 $ 299,223
Sales of released CMO collateral classified as held-to-maturity occasionally occur provided the collateral has paid down to within
15%10% of its original issuance amounts. Dispositions of debt securities were as follows (in thousands):
QUARTER ENDED NINE MONTHS ENDED SEPTEMBER 30 SEPTEMBER 30 -------------------------- -------------------------- 2003 2002 2003 2002 ---------- ---------- ---------- -----------Sale of securities held available-for-sale: Amortized cost $ 12,305 $ -- $ 63,053 $ -- Gain 183 -- 2,014 -- Sale of released CMO collateral held-to-maturity: Amortized cost 33,964 -- 56,720 -- Gain 1,037 -- 1,846 --
Quarter Ended March 31 2004 2003 Sale of debt securities held available-for-sale: Amortized cost $ — $ 28,540 Gain — 1,044 Sale of released CMO collateral held-to-maturity: Amortized cost — 4,006 Gain — 98 NOTE 11
--— COMPREHENSIVE INCOMEComprehensive income is net income plus other comprehensive income (loss), which, for the periods presented, consists primarily of the change in unrealized gain on debt securities classified as available-for-sale. The following table provides information regarding comprehensive income (in thousands):
QUARTER ENDED NINE MONTHS ENDED SEPTEMBER 30 SEPTEMBER 30 ----------------------- ----------------------- 2003 2002 2003 2002 -------- -------- -------- --------Net income $ 14,779 $ 22,751 $ 47,563 $ 75,712 -------- -------- -------- -------- Other comprehensive income (loss): Unrealized gain on Derivatives held as cash flow hedges: Change in unrealized gain during period 85 -- (184) (58) Reclassification adjustment for amounts included in net income (40) (52) (77) (177) -------- -------- -------- -------- 45 (52) (261) (235) Unrealized gain on debt securities: Change in unrealized gain during period (9,983) 1,913 (11,921) (2,221) Reclassification adjustment for gain included in net income (183) -- (2,014) -- -------- -------- -------- -------- Other comprehensive income (loss) (10,121) 1,861 (14,196) (2,456) -------- -------- -------- -------- Comprehensive income $ 4,658 $ 24,612 $ 33,367 $ 73,256 ======== ======== ======== ========
Quarter Ended March 31 2004 2003 Net income $ 12,354 $ 17,543
Other comprehensive income (loss): Unrealized gain on Derivatives held as cash flow hedges: Change in unrealized gain during period (128 ) (45 ) Reclassification adjustment for amounts included in net income (51 ) (27 )
(179 ) (72 ) Unrealized gain on debt securities: Change in unrealized gain during period 2,672 (161 ) Reclassification adjustment for gain included in net income — (1,044 )
Other comprehensive income (loss) 2,493 (1,277 )
Comprehensive income $ 14,847 $ 16,266
-13-
NOTE 12
-- NET INTEREST INCOME ANALYSIS The following tables summarize interest income and interest expense and weighted average interest rates pertaining to the Company's investments in financial assets (excludes investments in real estate and related borrowings) (dollars in thousands):
QUARTER ENDED SEPTEMBER 30 --------------------------------------------------------- 2003 2002 -------------------------- ------------------------ AMOUNT AVERAGE AMOUNT AVERAGE ---------- --------- ---------- ---------Interest income: Mortgage securities and similar investments $ 19,599 3.82% $ 34,866 5.04% CMO collateral and investments 5,971 5.99 26,316 6.73 ---------- ---------- Total interest income 25,570 61,182 ---------- ---------- Interest expense: Repurchase arrangements and similar borrowings 5,377 1.13 11,886 1.84 CMO borrowings 5,803 5.62 26,594 6.84 ---------- ---------- Total interest expense 11,180 38,480 ---------- ---------- $ 14,390 $ 22,702 ========== ==========NINE MONTHS ENDED SEPTEMBER 30 --------------------------------------------------------- 2003 2002 -------------------------- ------------------------ AMOUNT AVERAGE AMOUNT AVERAGE ---------- --------- ---------- ---------Interest income: Mortgage securities and similar investments $ 66,384 4.09% $ 120,701 5.32% CMO collateral and investments 31,061 6.26 94,446 6.98 ---------- ---------- Total interest income 97,445 215,147 ---------- ---------- Interest expense: Repurchase arrangements and similar borrowings 19,050 1.26 38,897 1.84 CMOs borrowings 31,152 6.24 95,559 7.11 ---------- ---------- Total interest expense 50,202 134,456 ---------- ---------- $ 47,243 $ 80,691 ========== ==========Changes in interest income and interest expense due to changes in interest rates versus changes in volume were as follows (in thousands):
QUARTER ENDED SEPTEMBER 30, 2003 --------------------------------------------- RATE* VOLUME* TOTAL ----------- ----------- -----------Interest income: Mortgage securities and similar investments $ (7,442) $ (7,825) $ (15,267) CMO collateral and investments (2,615) (17,730) (20,345) ----------- ----------- ----------- Total interest income (10,057) (25,555) (35,612) ----------- ----------- ----------- Interest expense: Repurchase arrangements and similar borrowings (3,866) (2,643) (6,509) CMO borrowings (4,068) (16,723) (20,791) ----------- ----------- ----------- Total interest expense (7,934) (19,366) (27,300) ----------- ----------- ----------- $ (2,123) $ (6,189) $ (8,312) =========== =========== ===========-14-
NINE MONTHS ENDED SEPTEMBER 30, 2003 --------------------------------------------- RATE* VOLUME* TOTAL ----------- ----------- -----------Interest income: Mortgage securities and similar investments $ (24,509) $ (29,808) $ (54,317) CMO collateral and investments (8,816) (54,569) (63,385) ----------- ----------- ----------- Total interest income (33,325) (84,377) (117,702) ----------- ----------- ----------- Interest expense: Repurchase arrangements and similar borrowings (10,444) (9,403) (19,847) CMO borrowings (10,491) (53,916) (64,407) ----------- ----------- ----------- Total interest expense (20,935) (63,319) (84,254) ----------- ----------- ----------- $ (12,390) $ (21,058) $ (33,448) =========== =========== ===========* The change in interest due to both volume and rate has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each. NOTE 13 -- COMMITMENTS AND CONTINGENCIES During 1998, twenty-four purported class action lawsuits were filed against Capstead and certain of its officers alleging, among other things, that the defendants violated federal securities laws by publicly issuing false and misleading statements and omitting disclosure of material adverse information regarding the Company's business. After these actions were consolidated and the court appointed a lead plaintiff group, an amended complaint was filed in October 2000. The amended complaint claims that as a result of alleged improper actions, the market prices of the Company's equity securities were artificially inflated during the period between April 17, 1997 and June 26, 1998 and seeks monetary damages in an undetermined amount. In February 2001, the Company and named officers responded to this amended complaint with motions to dismiss all allegations against the Company and the named officers. By order dated March 31, 2003, the court granted the Company and named officers' motions to dismiss and entered an order dismissing the amended complaint and denying the plaintiffs' request to further amend their complaint. In early November 2003, the plaintiff's opportunity to appeal this dismissal to the Fifth Circuit Court of Appeals passed. With the dismissal of this case without appeal, the Company expects to recover from its insurance carrier a $500,000 deductible originally expensed in 1998 and 1999. This recovery will be recorded in Other Revenue when received. NOTE 14 --— TRANSACTIONS WITH FORMER AFFILIATESFortress Investment Group, LLC (together with its affiliates, "Fortress") was Capstead's largest stockholder, holding approximately 26% of the outstanding common shares as recently as December 31, 2002. Since year-end, Fortress has sold its investment in Capstead.Pursuant to a management contract entered into in April 2000, Fortress provided the services of
Mr. Wesley R. Edensits chairman to serve asCapstead'sCapstead’s chairman and chief executive and of other individuals as necessary to perform support services forMr. Edens.him. On July 22, 2003,Mr. EdensFortress’ chairman resigned from hispositionpositions with Capstead and the management contract with Fortress was terminated. Under the terms of the contract, Fortress was entitled to a $375,000 base annual fee and participated with management and employees in an incentive fee program based on theCompany'sCompany’s expected performance against predetermined benchmarks established by members of the Board of Directors independent of Fortress. Included inOther operating expenseis$210,000$93,750 of base fees paid to Fortress for services renderedthrough July 22,during the three months ended March 31, 2003.In addition, Fortress was awarded $500,000 of incentive fees from amounts accrued through that date under this program.See NOTE 6 for information regardingFortress'Fortress’ involvement through its affiliate Brookdale in the acquisition and long-term leasing of senior living facilities acquired by Capstead in May 2002.-15-NOTE 13— NET INTEREST INCOME ANALYSIS
The following tables summarize interest income and interest expense and weighted average interest rates pertaining to the Company’s investments in financial assets (excludes investments in real estate and related borrowings) (dollars in thousands):
Quarter Ended March 31 2004 2003 Average Average Amount Rate Amount Rate Interest income: Mortgage securities and similar investments $ 19,437 3.42 % $ 25,137 4.35 % CMO collateral and investments 2,506 6.69 14,968 6.46
Total interest income 21,943 40,105
Interest expense: Repurchase arrangements and similar borrowings 5,830 1.11 % 7,219 1.34 CMOs 2,293 6.12 15,339 6.63
Total interest expense 8,123 22,558
$ 13,820 $ 17,547
Changes in interest income and interest expense due to changes in interest rates versus changes in volume were as follows (in thousands):
Quarter Ended March 31, 2004 Rate* Volume* Total Interest income: Mortgage securities and similar investments $ (5,342 ) $ (358 ) $ (5,700 ) CMO collateral and investments 515 (12,977 ) (12,462 )
Total interest income (4,827 ) (13,335 ) (18,162 )
Interest expense: Repurchase arrangements and similar borrowings (1,237 ) (152 ) (1,389 ) CMOs (1,096 ) (11,950 ) (13,046 )
Total interest expense (2,333 ) (12,102 ) (14,435 )
$ (2,494 ) $ (1,233 ) $ (3,727 )
* The change in interest due to both volume and rate has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each. -14-
ITEM 2.
MANAGEMENT'SMANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONSFINANCIAL CONDITION
OVERVIEWOverview
Capstead Mortgage Corporation
("Capstead"(“Capstead” or the"Company"“Company”) operates as a real estate investment trust("REIT"(“REIT”) earning income from investing in real estate-related assets on a leveraged basis and from other investment strategies. These investmentscurrently include,primarily consist of, but are not limited to,single-familyresidential adjustable-rate mortgage("ARM"(“ARM”) securities issued by government-sponsored entities, either Fannie Mae, Freddie Mac or Ginnie Mae("(“AgencySecurities"Securities”). The Company has also made limited investments in credit-sensitive commercial real estate-related assets, including the direct ownership of real estate. Management believes that such investments, when available at favorable prices and combined with the prudent use of leverage, can produce attractive risk-adjusted returns over the long term withlessrelatively low sensitivity to changes in interestrates due largely to a higher riskrates.The size and composition of
default and reduced liquidity compared to fixed-rate or medium-term Agency Securities. Capstead'sthe Company’s investment portfoliosdeclineddepend on thelastinvestment strategies being implemented by management and market conditions being experienced by the Company, including levels of mortgage prepayments and the availability of attractively priced investments. After several years of steadily declining mortgage securities portfolio balances, primarily because of high levels of mortgage prepayments and a lack ofsuitablecompelling investment opportunities, during the latter half of 2003 market conditions allowed for the acquisition of sufficient ARM securities atfavorable prices. Consequently,relatively attractive prices to more than offset portfolio runoff. This opportunity became available when long-term interest rates moved sharply higher in2001response to indications that the economy was recovering from a sustained period of economic weakness.Although this optimism proved premature and interest rates declined during the first quarter in response to weak job growth and other indications of economic weakness, the Company has been successful this quarter in acquiring sufficient ARM securities, again
in January 2003 (withat relatively attractive prices, to more than offset portfolio runoff. These acquisitions have allowed for thepaymentsequential growth of thefourth quarter 2002 common dividend), Capstead returned a significant portion of its equity capitalmortgage securities portfolio for the past three quarters and this trend is expected toits common stockholders. To the extent proceeds of runoff or asset sales are not reinvested, or cannot be reinvested, at a rate of returncontinue at leastequalthrough the second quarter of 2004. The Company intends to continue pursuing therate previouslyacquisition of attractively priced ARM securities, while also investigating other real estate-related opportunities.Subsequent to quarter-end, recent strong economic indicators have many believing the Federal Reserve could be forced to begin raising short-term interest rates later this year and long-term interest rates have moved higher in response. Although higher interest rates may create opportunities to acquire additional investments at attractive prices, higher short-term interest rates will increase the Company’s borrowing costs, thereby reducing financing spreads (the difference between the yields earned on
that capital, quarterlythese investments and the rates charged on related borrowings). Although rising borrowing costs can eventually be mitigated by ARM security yield increases, interest rates on the Company’s borrowings rise (and fall) almost immediately while ARM security yields change slowly by comparison because the underlying loans reset only once or twice a year and the amount of each reset can be limited or capped. Consequently, while the wide financing spreads Capstead has enjoyed in recent years have been the driving force behind the Company’s earnings andcommondividends, if short-term interest rates rise quickly, spreads willlikely continue trending lower. The future sizenarrow andcomposition of Capstead's investment portfoliosmargins earned on its ARM securities willdepend on market conditions, including levels of mortgage prepayments anddecline.-15-
Risk Factors
Under the
availability on a timely basis of suitable investments at favorable prices (see "Effectscaptions “Effects of InterestRateChanges," "Risks” “Risks Associated with Credit-SensitiveInvestments" and "RisksInvestments,” “Risks Associated with Owning RealEstate"). MANAGEMENT CHANGES Fortress Investment Group, LLC (together with its affiliates, "Fortress") was Capstead's largest stockholder, holding approximately 26%Estate” and “Investment Company Act ofthe outstanding common shares as recently as December 31, 2002. By July 2003, Fortress sold its investment in Capstead. Pursuant1940” are discussions of risk factors affecting Capstead’s financial condition and results of operations that are an integral part of this discussion and analysis. Readers are strongly urged toa management contract entered into in April 2000, Fortress provided the services of Mr. Wesley R. Edens as Capstead's chairmanconsider these factors while reading this document.Mortgage Securities and
chief executive and of other individuals as necessary to perform support services for Mr. Edens. On July 22, 2003 Mr. Edens resigned from his positions with Capstead and the management contract with Fortress was terminated. Robert I. Kauffman, an associate of Mr. Edens and a director since December 1999, also resigned effective July 22, 2003. Paul M. Low, one of Capstead's founders and a long-time member of the Board of Directors, succeeded Mr. Edens as Chairman. Andrew F. Jacobs, formerly Executive Vice President and Chief Financial Officer, was promoted to Chief Executive Officer and President and elected to serve on the Board of Directors. Phillip A. Reinsch, Senior Vice President -- Control, was promoted to Chief Financial Officer. BOOK VALUE PER COMMON SHARESimilar InvestmentsAs of
September 30, 2003,March 31, 2004, theCompany's book value per common share was $7.05, a decline of $0.78 during the current quarter and $1.18 since December 31, 2002. Book value declined since year-end because of dividend payments in excess of quarterly net income (approximately $0.16 per share) and, more significantly, a reduction in the aggregate unrealized gain on the Company's investments (most of which are debt securities carried at fair value with changes in fair value reflected in stockholders' -16-equity) as a result of recent increases in interest rates and runoff caused by mortgage prepayments. This unrealized gain can be expected to continue to decline with runoff and to fluctuate with changes in interest rates and market liquidity, and such changes will largely be reflected in book value per common share. Book value will also be affected by other factors, including the level of dividend distributions and depreciation charges on net-leased real estate; however, temporary changes in fair values of investments not held in the form of debt or equity securities generally will not affect book value. MORTGAGE SECURITIES AND SIMILAR INVESTMENTS As of September 30, 2003,mortgage securities and similar investments portfolio consisted primarily of ARM AgencySecurities (see "NOTE 4" to the accompanying consolidated financial statements for discussion of how the Company classifies its mortgage securities and similar investments).Securities. Agency Securities are AAA-rated and are considered to have limited credit risk. Non-agency securities are private mortgage pass-through securities whereby the related credit risk of the underlying loans iseitherborne by AAA-rated private mortgage insurers or by the Company("(“Non-agencySecurities"Securities”).In connection with the formation of private mortgage pass-through securities prior to 1995, the Company was required to establish reserve funds available to pay special hazard (e.g. earthquake or mudslide-related losses) or certain bankruptcy costs. These securities were subsequently held as Non-agency Securities, CMO collateral or sold to third parties. Included in Receivables and other assets as restricted cash are $4.9 million in special hazard reserve funds and $1.2 million of bankruptcy reserve funds associated with $55 million and $57 million of related loans outstanding as of September 30, 2003, respectively.Commercial mortgage-backed securitizations generally have senior, mezzanine and subordinate classes of bonds with the lower classes providing credit enhancement to the more senior classes. Commercial mortgage-backed securities("CMBS"(“CMBS”) held by the Company atSeptember 30, 2003March 31, 2004 are mezzanine classes and therefore carry credit risk associated with the underlying pools of commercial mortgage loans that is mitigated by subordinate bonds held by other investors.Commercial loansMortgage securities held by
the Company at September 30, 2003 consist of a loan to a joint venture that holds commercial real estate (see "Risks Associated With Credit-Sensitive Investments"). Mortgage securitiesCapstead are financed under repurchase arrangements with investment banking firms pursuant to which specific securities are pledged as collateral.Capstead financed its commercial loan investment with a loan from a commercial bank.Should the Company acquireadditionalfinancial assets that are not mortgage-backed securities, similar financing arrangements with other parties, such as commercial banks, may be employed (see"Liquidity“Liquidity and CapitalResources"Resources”).The Company’s mortgage securities and similar investments portfolio rose during the first quarter of 2004 to $2.4 billion from $2.2 billion at December 31, 2003, representing the third straight quarter of portfolio growth after several years of declines. Acquisitions during the first quarter totaled $360 million, consisting almost exclusively of ARM Agency Securities. Runoff during the first quarter totaled $148 million, significantly less than the $225 million experienced during the fourth quarter of 2003, primarily reflecting lower levels of mortgage prepayments. Although mortgage prepayments moderated considerably during the first quarter of 2004, runoff caused by mortgage prepayments remains a
significantchallenge to earnings generated by theCompany'sCompany’s mortgage securities. The Company anticipates that runoff will be higher in the second quarter than in the first quarter due to lower prevailing mortgage rates in February and March before again declining to more moderate levels. The Company also securitized with Fannie Mae $53 million of its high coupon fixed-rate Non-Agency Securities in order to improve these securities’ financing spreads and liquidity.Although the Company has had continued success subsequent to quarter-end acquiring additional ARM securities
and similar investments. After experiencingsuch that it expects further portfoliodeclines to nearly $2.0 billion at June 30, 2003 from $2.4 billion at December 31, 2002,growth during thethirdsecond quarterthe Company had the opportunity to acquire $163 million inof 2004, there can be no assurance that attractively priced ARMAgency Securities at attractive prices after sharp increases in medium and long-term interest rates in July and August. In addition, during the third quarter Capstead transferred into this portfolio $121 million in fixed-rate collateral released from financed CMOs that the Company expectssecurities willearn improved financing spreads (the difference between yields earned on investments and the rates charged on related borrowings) than when financed by CMO bonds. Together, these additions more than offset third quarter runoff such that the portfolio ended the quarter at $2.1 billion. Prior to this third quarter activity, additions to this portfolio during 2003 were limited to $49 million of adjustable-rate collateral released from financed CMOs. Interest rates declined again in September and although management believes there maycontinue to beopportunities to acquire assets at attractive prices in the near future, such acquisitions may not be sufficient to replace runoff. That being said, runoff is expected to begin moderating in the fourth quarter as a higher interest rate environment has reduced, if not eliminated, the opportunity for homeowners to refinance their ARM loans into lower rate fixed-rate loans.available. To the extent the proceeds of mortgage-17-prepayments and other maturities are not reinvested or cannot be reinvested at a rate of return on invested capital at least equal to the return earned on previous investments, quarterlyearnings and common dividends maylikely continue trending lower.decline. The future size and composition of theCompany'sCompany’s investment portfolios will depend on market conditions, including levels of mortgage prepayments and the availability ofsuitable investments at favorable prices (see "Effects of Interest Rate Changes").attractively priced investments.The following yield and cost analysis illustrates results achieved during the
thirdfirst quarter of20032004 for components of the mortgage securities and similar investments portfolio and anticipatedfourthsecond quarter2003-16-
2004 asset yields and borrowing rates based on interest rates in effect on
OctoberApril 22,20032004 (the datethirdfirst quarter20032004 results were released) (dollars in thousands):
1st Quarter Average(a) As of March 31, 2004 Projected Lifetime Actual Actual Premiums 2nd Quarter Prepayment Basis Yield/Cost Runoff (Discounts) Basis(a) Yield/Cost(b) Assumptions Agency Securities: Fannie Mae/Freddie Mac: Fixed-rate 2,051 9.79 % 14 % $ 151 $ 55,083 6.23 % 30 % ARMs: LIBOR/CMT 1,127,291 3.16 20 20,054 1,212,893 2.90 25 COFI 85,678 4.36 24 (2,451 ) 82,293 4.44 25 Ginnie Mae ARMs 791,686 3.43 24 8,775 839,714 3.22 26
2,006,706 3.33 22 26,529 2,189,983 3.16 26 Non-agency Securities: Fixed-rate 110,796 6.15 48 69 48,707 6.38 32 ARMs 77,427 3.07 40 1,057 72,521 3.36 40
188,223 4.88 45 1,126 121,228 4.57 37 CMBS 73,377 2.19 6 (3 ) 73,216 2.27 —
2,268,306 3.42 24 $ 27,652 2,384,427 3.20 25
Borrowings 2,080,754 1.11 2,168,419 1.10
Capital employed/ financing spread $ 187,552 2.31 $ 216,008 2.10
2.39 2.19
3RD QUARTER AVERAGE(a) AS OF SEPTEMBER 30, 2003 ------------------------------------- ---------------------------- PROJECTED LIFETIME ACTUAL ACTUAL PREMIUMS 4TH QUARTER PREPAYMENT BASIS YIELD/COST RUNOFF (DISCOUNTS) BASIS (a) YIELD/COST (b) ASSUMPTIONS ------------ ------------ --------- ------------- ------------ -------------- -------------Agency Securities: Fannie Mae/Freddie Mac: Fixed-rate $ 2,566 9.41% 39% $ 14 $ 2,364 9.50% 30% ARMs: LIBOR/CMT 945,915 3.43 29 13,416 950,959 3.18 25 COFI 102,189 4.83 30 (2,878) 96,650 4.64 25 Ginnie Mae ARMs 685,978 3.85 43 7,639 714,234 3.64 26 ---------- ---------- ---------- 1,736,648 3.69 35 18,191 1,764,207 3.45 25 Non-agency Securities: Fixed-rate 97,189 6.47 30 429 122,823 6.22 32 ARMs 103,099 3.00 50 1,538 93,566 3.37 40 ---------- ---------- ---------- 200,288 4.68 41 1,967 216,389 5.10 35 CMBSBasis represents the Company’s investment before unrealized gains and other commercial loans 108,273 4.27 2 1 108,057 4.28 -- ---------- ---------- ---------- 2,045,209 3.82 35 $ 20,159 $2,088,653 3.67 25 ========== Borrowings 1,865,726 1.13 1,994,389 1.15 ---------- ---------- Capital employed/losses. Actual asset yields, runoff rates, borrowing rates and resulting financing spread$ 179,483 2.69 $ 94,264 2.52 ========== ==========are presented on an annualized basis.(b) Projected annualized yields for the second quarter of 2004 reflect ARM coupon resets and lifetime prepayment assumptions as adjusted for expected prepayments for this quarter only, as of April 22, 2004. Actual yields realized in future periods will largely depend upon (i) changes in portfolio composition, (ii) ARM coupon resets, (iii) actual prepayments and (iv) any changes in lifetime prepayment assumptions. (c) The Company generally uses its liquidity to pay down borrowings. Return on assets (c) 2.77 2.60is calculated on an annualized basis assuming the use of this liquidity to reduce borrowing costs (see “Utilization of Capital and Potential Liquidity”).(a) Basis representsFinancing spreads declined 16 basis points during the
Company's investment before unrealized gains and losses. Actual asset yields, runoff rates, borrowing rates and resulting financing spread are presented on an annualized basis. (b) Projected annualized yields for the fourthfirst quarter of2003 reflect ARM coupon resets and lifetime prepayment assumptions as adjusted for expected prepayments for this quarter only, as of October 22, 2003. Actual yields realized in future periods will largely depend upon (i) changes in2004 to 2.31%, substantially all attributable to lower portfoliocomposition, (ii) ARM coupon resets, (iii) actual prepayments and (iv) any changes in lifetime prepayment assumptions. (c) The Company generally uses its liquidity to pay down borrowings. Return on assets is calculated on an annualized basis assuming the use of this liquidity to reduce borrowing costs (see "Utilization of Capital and Potential Liquidity").yields. The overall yield earned on the portfolio averaged3.82%3.42% during thethirdfirst quarter,of 2003, a decline of 24 basis points fromcompared to an average yield of4.06%3.60% earned during the previousquarter and 83 basis points from the average yield earned during the fourth quarter of 2002.quarter. Yields on ARM securities fluctuate as coupon interest rates on the underlying mortgage loans reset to reflect current interest rates and are expected to continue to decline in the coming quarters. For example, if interest ratesstabilizeremain at rates in effectOctoberApril 22,2003,2004, the average yield on the portfolio could decline approximately3837 basis points by thethirdfirst quarter of2004.2005. Actual yields will depend on portfolio composition as well as fluctuations in, and market expectations for fluctuations in, interest rates and levels of mortgageprepayments (see "Effects of Interest Rate Changes"). -18-prepayments. Average rates on related borrowings were 1.13%declined 2 basis points to 1.11% during thethirdfirst quarter of2003, a decline of 17 basis points from2004 compared to thesecond quarter and 49 basis points from average borrowing rates incurred during the fourth quarter of 2002.previous quarter. TheCompany'sCompany’s borrowing rates depend on actions by the Federal Reserve to change short-term interest rates, market expectations of future changes in short-term interest rates and the extent of changes in financial marketliquidity (see "Effects of Interest Rate Changes").liquidity.-17-
CMO
COLLATERAL AND INVESTMENTSCollateral and InvestmentsSince exiting the residential mortgage loan conduit business in 1995, Capstead has maintained finance subsidiaries with capacity to issue CMOs and other securitizations backed by
single-familyresidential mortgage loans.From time to time, the Company may purchase mortgage loans from originators or conduits, place these loans into private mortgage pass-through securities and issue CMOs or other securities backed by these securities.TheCompany may or may not retain a significant residual economic interest in these securitizations. Credit risk associated with pledgedlast CMOcollateral is borne by AAA-rated private mortgage insurers or by subordinated bonds usually sold to investors. With recent redemptions of previously-issued CMOs, the Company no longer has credit risk held in the form of subordinated bonds associated with outstanding pledged CMO collateral. Most of the Company's securitizations have been afforded financing accounting treatment with the related collateral recorded as pledged CMO collateral and the outstanding bonds recorded as CMO liabilities (referred to as "financed CMOs"). Other securitizationsissued by the Company was in19932000 andprior were treated as sales transactions (referred to as "sold CMOs"). Since 2000,the Companyhasdoes notissued anycurrently anticipate issuing additional CMOs.From time to time,In recent years, the Company has exercised its right to redeem previously issued CMOs (referred to as"clean-up calls"“Clean-up Calls”)and has either sold or transferredselling some of the released collateraltoand holding theNon-agency Securities portfolio where it has been heldrest for investment.During the first nine months of 2003, the Company exercised clean-up calls related to ten financed CMOs and three sold CMOs.As ofSeptember 30, 2003,March 31, 2004, the Company holdsclean-up callClean-up Call rights ontwoonly one of itssevensix remainingfinancedCMOs. Consequently, additional significant gains from CMO redemptions are not expected tooccur in the coming quarters.occur.CMO collateral and investments, net of related bonds,
declined from $8.6 millionwas $673,000 atyear-endMarch 31, 2004, compared to$963,000$764,000 atSeptember 30, 2003, as a result of portfolio runoff and exercising clean-up calls as discussed above.December 31, 2003. Without the issuance of CMOs in which the Company retains residual interests, or the acquisition of other CMO investments, this portfolio is not expected to contribute significantly to operating results in future periods.REAL ESTATE HELD FOR LEASEReal Estate Held For Lease
In May 2002 Capstead acquired six
"independent"“independent” senior living properties (wherein the operator of the facility provides most of the tenants little, if any, medical care) (the"Properties"“Properties”).The following table summarizes information about the Properties:
YEAR PROPERTY LOCATION UNITS (a) OCCUPANCY (b) OPENED --------------------------- ----------------- ------------------ ------------ ---------Chambrel at Roswell Roswell, GA 280 (256 IL; 24 AL) 95.7% 1987 Chambrel at Pinecastle Ocala, FL 161 (120 IL; 41 AL) 98.8 1987 Chambrel at Island Lake Longwood, FL 269 (229 IL; 40 AL) 97.4 1985 Chambrel at Montrose Akron, OH 168 (136 IL; 32 AL) 98.8 1987 Chambrel at Williamsburg Williamsburg, VA 255 (200 IL; 55 AL) 98.4 1987 Chambrel at Club Hill Garland, TX 260 (192 IL; 68 AL) 92.3 1987 ------------------------ Total 1,393 (1,133 IL; 260 AL) 96.6 ========================(a) IL refers to Independent Living units, AL refers to Assisted Living units. (b) As of September 30, 2003. -19-Concurrent with the acquisition of the Properties, the Company entered into a long-term "net-lease"“net-lease” arrangement (the"Lease"“Lease”) with Brookdale Living Communities, Inc.(collectively with its subsidiaries, "Brookdale", (“Brookdale”), under which Brookdale is responsible for the ongoing operation and management of the Properties. Brookdale, an owner, operator, developer and manager of senior living facilities, is a majority-owned affiliate of Fortress Investment Group, LLC, which, together with its affiliates is referred to as Fortress. Until July 2003 Fortress was affiliated with Capstead (see NOTE 12 to the accompanying financial statements).The Lease has an initial term of 20 years and provides for two 10-year renewal periods. Beginning in May 2007, Brookdale will have the option of purchasing all of the Properties from Capstead at the greater of fair value or
Capstead'sCapstead’s original cost, after certain adjustments. Under the terms of the Lease, Brookdale is responsible for paying all expenses associated with operating the Properties, including real estate taxes, other government charges, insurance, utilities and maintenance, and an amount representing an attractive cash return onCapstead'sCapstead’s equity in the Properties after payment of monthly debt service. In keeping withCapstead'sCapstead’s strategy ofreinvesting a portion of its capital intoowning investments that can produce attractive risk-adjusted returns over the long term withlessrelatively low sensitivity to changes in interest rates, any future changes in monthly debt service requirements are the responsibility of Brookdale under the terms of theLease (see "Risks AssociatedLease. The following table summarizes information about the Properties:
Year Property Location Units (a) Occupancy(b) Opened Chambrel at Roswell Roswell, GA 280 (256 IL; 24 AL) 95.4 % 1987 Chambrel at Pinecastle Ocala, FL 161 (120 IL; 41 AL) 96.9 1987 Chambrel at Island Lake Longwood, FL 269 (229 IL; 40 AL) 97.8 1985 Chambrel at Montrose Akron, OH 168 (136 IL; 32 AL) 97.0 1987 Chambrel at Williamsburg Williamsburg, VA 255 (200 IL; 55 AL) 98.8 1987 Chambrel at Club Hill Garland, TX 260 (192 IL; 68 AL) 89.6 1987
Total 1,393 (1,133 IL; 260 AL) 95.8
(a) IL refers to independent living units. AL refers to assisted living units. (b) As of March 31, 2004. -18-
Results of Capital Raising Activity
Between February 2 and March 30, 2004, the Company sold 791,900 common shares into the open market on a limited basis and such sales may resume during the second quarter. As of quarter-end, Capstead raised $13.4 million of new common equity under this program at an average price of $16.94 per share, after expenses. The proceeds from these issuances have been invested in attractively-priced ARM securities.
Book Value per Common Share
As of March 31, 2004, the Company’s book value per common share was $7.38, an increase of $0.70 since year-end. This increase is largely attributable to the issuance of new capital (approximately $0.55 per share), offset somewhat by dividend payments in excess of quarterly net income (approximately $0.04 per share). In addition, lower prevailing interest rates at quarter-end resulted in an increase in the aggregate unrealized gain on the Company’s investments (most of which are debt securities carried at fair value with
Owning Real Estate")changes in fair value reflected in stockholders’ equity).UTILIZATION OF CAPITAL AND POTENTIAL LIQUIDITYThis unrealized gain can be expected to fluctuate with changes in portfolio size and composition as well as changes in interest rates and market liquidity, and such changes will largely be reflected in book value per common share. Book value will also be affected by other factors, including capital stock transactions and the level of dividend distributions relative to quarterly net income; however, temporary changes in fair values of investments not carried at fair value on the Company’s balance sheet generally will not affect book value.Utilization of Capital and Potential Liquidity
The following table illustrates
Capstead'sCapstead’s utilization of capital and potential liquidity as ofSeptember 30, 2003March 31, 2004 in comparison with December 31,20022003 (in thousands):
Capital Potential Assets Borrowings Employed Liquidity(a) Mortgage securities and similar investments: Agency Securities $ 2,219,743 $ 2,003,717 $ 216,026 $ 154,995 Non-agency Securities 122,202 95,834 26,368 19,054 CMBS 73,219 68,868 4,351 334
2,415,164 2,168,419 246,745 174,383 CMO collateral and investments 129,302 128,629 673 — Real estate held for lease 132,487 120,154 12,333 —
$ 2,676,953 $ 2,417,202 259,751 174,383
Other assets, net of other liabilities 40,974 2,896 (b) First quarter common dividend (7,807 ) (7,807 )(c) Liquidity reserves for funding principal payments and margin calls — (130,006 )(d)
$ 292,918 $ 39,466
Balances as of December 31, 2003 $ 2,496,102 $ 2,262,191 $ 277,038 $ 44,999
CAPITAL POTENTIAL ASSETS BORROWINGS EMPLOYED LIQUIDITY(a) ---------- ---------- ---------- -------------Mortgage securitiesAssets are stated at carrying amounts on the Company’s balance sheet. Potential liquidity is based on maximum borrowings available under existing uncommitted repurchase arrangements considering the fair value of related collateral as of March 31, 2004, adjusted separately for liquidity reserves. (b) Represents unrestricted cash and similar investments: Agency Securities $1,795,320 $1,721,332 $ 73,988 $ 21,068 Non-agency Securities 217,577 178,548 39,029 32,823 CMBS and other commercial loans 108,077 94,509 13,568 327 ---------- ---------- ---------- ---------- 2,120,974 1,994,389 126,585 54,218 CMO collateral and investments 240,528 239,565 963 -- Real estate held for lease 134,341 120,253 14,088 -- ---------- ---------- ---------- ---------- $2,495,843 $2,354,207 141,636 54,218 ========== ========== Other assets, net of other liabilities 151,218 98,025(b) Secondcash equivalents.(c) The first quarter 2004 common dividend (10,513) (10,513)(c) ---------- ---------- $ 282,341 $ 141,730 ========== ========== Balanceswas declared March 11, 2004 and paid April 21, 2004 to stockholders of record as ofDecemberMarch 31,2002 $3,652,062 $3,340,835 $ 298,578 $ 143,033 ========== ========== ========== ==========2004.(d) Liquidity reserves reflect management’s determination, as of the balance sheet date, of the level of capital necessary to hold in reserve to fund margin calls (requirements to pledge additional collateral or pay down borrowings) required by principal payments (that are not remitted to the Company for 25 to 45 days after any given month-end) and potential declines in market value of pledged assets under stressed market conditions. (a) Based on maximum borrowings available under existing uncommitted repurchase arrangements considering the fair value of related collateral as of September 30, 2003 (see "Liquidity and Capital Resources"). (b) Represents unrestricted cash and cash equivalents. (c) The third quarter common dividend was declared September 11, 2003 and paid October 21, 2003 to stockholders of record as of September 30, 2003.-19-
The Company generally finances its mortgage securities and similar investments with well-established investment banking firms using repurchase arrangements and similar borrowings. Assuming potential liquidity is available, these borrowings can be increased or decreased on a daily basis to meet cash flow requirements and otherwise manage capital resources efficiently. CMO collateral is pledged to secure CMO bonds. Real estate held for lease is financed by long-term borrowings. Liquidity is affected by, among other things, changes in market value of assets pledged under
repurchase and similarborrowing arrangements, principal prepayments and general conditions in the investment banking, mortgage finance and real estate industries. Future levels of financial leverage will be dependent upon many factors, including the size and composition of theCompany'sCompany’s investment portfolios (see"Liquidity“Liquidity and CapitalResources" and "Effects of Interest Rate Changes"Resources”).-20-
RESULTS OF OPERATIONS
Comparative net operating results (interest income or lease revenue, net of related interest expense
real estate depreciationand, in the case of CMO administration, related direct and indirect operating expense) by source were as follows (in thousands, except per share amounts):
Quarter Ended March 31 2004 2003 Mortgage securities and similar investments: Agency Securities $ 11,673 $ 15,786 Non-agency Securities 1,701 1,045 CMBS and other commercial loans 182 1,014 CMO collateral and investments 217 (407 )
Net margin on financial assets 13,773 17,438 Real estate held for lease: Lease revenue after related interest expense 1,440 1,429 Real estate depreciation (927 ) (927 )
Net margin on real estate held for lease 513 502
Other revenue (expense): Gain on asset sales and CMO redemptions — 1,748 CMO administration and other 67 220 Incentive fee payable to former affiliate — (303 ) Other operating expense (1,999 ) (2,062 )
Total other revenue (expense) (1,932 ) (397 )
Net income 12,354 17,543 Less cash dividends on preferred shares (5,067 ) (5,070 )
Net income available to common stockholders $ 7,287 $ 12,473
Operating income * $ 8,298 $ 11,739
Net income per common share: Basic $ 0.51 $ 0.90 Diluted 0.50 0.75 Operating * 0.57 0.82
QUARTER ENDED NINE MONTHS ENDED SEPTEMBER 30 SEPTEMBER 30 -------------------- -------------------- 2003 2002 2003 2002 -------- -------- -------- --------Mortgage securities and similar investments: Agency securities $ 11,476 $ 20,247 $ 40,457 $ 74,127 Non-agency Securities 1,974 890 4,048 3,059 CMBS and other commercial loans 710 1,762 2,627 4,363 CMO collateral and investments 137 (341) (190) (1,326) -------- -------- -------- -------- Net margin on* Capstead reports operating income per common share (a non-GAAP financial assets 14,297 22,558 46,942 80,223 -------- -------- -------- -------- Real estate held for lease: Lease revenue net of related interest expense 1,422 1,301 4,293 2,192 Real estatemeasure calculated excluding depreciation(927) (962) (2,781) (1,604) -------- -------- -------- -------- Net marginon real estate,held for lease 495 339 1,512 588 -------- -------- -------- -------- Other revenue (expense): Gainany gain on asset sales and CMO redemptions,1,411 1,901 4,551 1,901 CMO administrationandother 459 914 860 2,114 Incentive fee payablethe dilutive effects, if present, of the Series B preferred shares) under the belief it provides investors with a useful supplemental measure of the Company’s operating performance. Operating income represents a measure of the amount of funds generated by operations, which may, at the discretion of Capstead’s Board of Directors, be used for reinvestment or distributed toformer affiliate -- (1,351) (500) (4,034) Othercommon stockholders as dividends. Depreciation on real estate, although an expense deductible for federal income tax purposes and therefore an item that reduces Capstead’s REIT distribution requirements, is added back to arrive at operatingexpense (1,883) (1,610) (5,802) (5,080) -------- -------- -------- -------- Total other revenue (expense) (13) (146) (891) (5,099) -------- -------- -------- -------- Netincome$ 14,779 $ 22,751 $ 47,563 $ 75,712 ======== ======== ======== ======== Netbecause it is a noncash expense. Gains are excluded because they are considered non-operating in nature and the amount and timing of any such gains are dependent upon investment strategies and market conditions. The Series B preferred shares are considered dilutive, for diluted net income per commonshare: Basic $ 0.69 $ 1.27 $ 2.32 $ 4.36 Diluted 0.63 1.15 2.04 3.82 Operating * 0.65 1.19 2.15 4.27* Capstead reports operating income per common share (a non-GAAP financial measure calculated excluding depreciation on real estate, gain on asset sales and CMO redemptions, and the dilutive effects of the Series B preferred share) under the belief it provides investors with a useful supplemental measure of the Company's operating performance. Depreciation on real estate, although an expense deductible for federal income tax purposes and therefore an item that reduces Capstead's REIT distribution requirements, is added back to arrive at operating income because it is a noncash expense. Gains are excluded because they are considered non-operating in nature and the amount and timing of any such gains are dependent upon market conditions. Operating income per common share excludes the dilutive effects of the Series B preferred shares because it is not economically advantageous to convert these shares at the current market prices of both the common shares and Series B preferred shares (see "Comparison of Operating Income and Diluted Income per Common Share")share purposes only, whenever annualized basic net income per common share exceeds $2.19 (the Series B preferred share annualized dividend of $1.26 divided by the current conversion rate of 0.5742). Because it is not economically advantageous to convert these shares at market prices of both the common shares and Series B preferred shares, few, if any, actual Series B conversions are expected. Therefore, operating income per common share excludes the dilutive effects, if present, of the Series B preferred shares.-21-
The earning capacity of
Capstead'sCapstead’s financial asset portfolios is influenced by the overall size and composition of the portfolios, the relationship between short- and long-term interest rates (the"yield curve"“yield curve”) and the extent the Company continues to invest its liquidity in these portfolios. Net margins on financial assets and related financing spreads havedeclined steadily since peaking in early 2002 after havingbenefited significantly the past several years from actions taken by the Federal Reserve, particularly during 2001, toaggressivelylower short-term interest rates, which resulted in significantly lower interest rates on theCompany'sCompany’s borrowings. However, lower interest rates have also led to declining yields on theCompany'sCompany’s adjustable-rate assets-21-and more significantly,declining portfolio balances primarily caused by relatively high mortgage prepayment rates.Net margins andWhile financing spreadsmayare expected to continue declining as yields on theCompany'sCompany’s ARM securities continue resetting lower,particularlythe Company has had success recently in replacing runoff that, if it continues, should slow declines in net margins provided borrowing rates stay at current levels. See “Financial Condition — “Overview” and “Mortgage Securities and Similar Investments” for further discussion of the current operating environment and the Company’s goals regarding redeploying capital made available by portfoliobalances because of scheduled principal payments, maturities and mortgage prepayments are not offset by acquisitions of new mortgage assets (see "Effects of Interest Rate Changes").runoff.Agency Securities remained the primary contributor to operating results during the quarter
and nine monthsendedSeptember 30, 2003;March 31, 2004; however, the impact of loweryields and a significantly lower average outstanding portfoliofinancing spreads was evident in the currentyearquarter results, which weresignificantlyless than in the sameperiodsperiod in20022003 despite lower borrowing rates. Yields for this portfolio averaged3.69% and 4.02%3.33% during the current quarter,and nine months ended September 30, 2003, compared to 4.99% and 5.32% during the same periods in 2002,while borrowing rates averaged1.06%1.07%, producing a financing spread of 2.26%. This compares with yields of 4.30% and1.21%borrowing rates of 1.30% forthe quarter and nine months ended September 30, 2003 compared to 1.79% and 1.80%a spread of 3.00% during the sameperiodsperiod in2002.2003. The average outstanding Agency Securities portfolio was$1.7$2.0 billionand $1.9 billion forduring the current quarterand nine months ended September 30, 2003compared to$2.5 billion and $2.7$2.1 billion during the sameperiodsperiod in2002.2003.Conversely, Non-agency Securities contributed more to operating results during the quarter
and nine monthsendedSeptember 30, 2003March 31, 2004 compared to the sameperiodsperiod in20022003 primarily because of the benefits of additional securities made available from the redemption ofCMOs.CMOs during the latter part of 2003. The average outstanding portfolio was$200 million and $144$188 million during the current quarterand nine months ended September 30, 2003compared to$83 million and $88$99 million during the sameperiodsperiod in2002. Yields for this2003. The portfolio(calculated including mortgage insurance costs) were lower averaging 4.68% and 4.45%yielded 4.88% during the current quarter,and nine months ended September 30, 2003 compared to 5.25% and 5.71% during the same periods in 2002,while borrowing rates averaged1.45%1.52% producing a financing spread of 3.36%. This compares with yields of 4.81% and borrowing rates of 1.41% forboth the current quarter and year-to-date periods compared to 1.87% and 1.92%a spread of 3.40% during the sameperiodsperiod in2002.2003.CMBS and other commercial loans contributed significantly less to operating results during the quarter
and nine monthsendedSeptember 30, 2003March 31, 2004 than in the sameperiodsperiod in2002 primarily because of a lower average outstanding portfolio with2003 due largely to payoffs during 2003 of severalpositions held by the Company throughout all of last year.higher yielding investments. The average outstanding portfolio was$108 million and $120$73 million during the current quarterand nine months ended September 30, 2003compared to$199$142 millionfor both periodsduring the same period in2002.2003. The portfolio yielded4.27% and 4.69%2.19% during the current quarterand nine months ended September 30, 2003while borrowing rates averaged1.95% and 2.06%1.29% producing financing spreads of2.32% and 2.63%, respectively.0.90%. This compares with yields of5.56% and 5.01%4.68% and borrowing rates of2.50% and 2.48%2.09% forspreadsa spread of3.06% and 2.53%, respectively,2.59% during the sameperiodsperiod in2002. Because this portfolio currently consists of adjustable-rate assets secured by borrowings with similar interest rate adjustment features, future changes in short-term interest rates should have little effect on financing spreads.2003.The CMO collateral and investments portfolio has declined significantly the last several years primarily because of high prepayments on the underlying pledged CMO collateral and the exercise of
clean-up callsClean-up Calls in which the Companyretiredredeemed the related bonds and either sold the released CMO collateral for gains or transferred it into the Non-agency Securities portfolio where it is held forinvestment (see "Financial Condition -- CMO Collateral and Investments"). In May 2002investment.Having redeemed over the past several years nearly all outstanding CMOs to which the Company
made its first direct investment in real estate that is net-leased on a long-term basis. Under the terms of the Lease, changes in interest rates onholds the relateddebt are the responsibility of the lessee. Current quarter results were higher than the third quarter of 2002 primarily because of an annual rent escalation effective each May 1 and lower depreciation expense because of the October 2002 sale of a skilled nursing facility acquired with these six independent living properties. Because real estate -22-held for lease was acquired May 1, 2002, the nine months ended September 30, 2002 only includes five months ownership of these properties (see "Financial Condition -- Real Estate Held For Lease"). GainClean-up Call rights, Capstead did not realize any gain on asset sales and CMO redemptionsreflectin thesale of $120 million of released CMO collateral and gains on the redemption of CMO bonds related to $170 million in collateral held as Non-agency securities upon release from the related indentures. The Company does not anticipate realizing significant additional gains from the redemption of previously-issued securitizations.current quarter.CMO administration revenue continues to trend lower primarily because a declining portfolio of CMOs for which the Company provides administrative services. As these CMOs pay down, related fee income is expected to decline. Other revenue was lower due to lower balances in overnight investments during
2003. On a combined basis,the current quarter.-22-
Other operating expenses (including incentive fees payable to
Fortress,former affiliate) were lower for theCompany's former affiliate, and other operating expenses were considerably less during thecurrent quarterand nine months ended September 30, 2003than during the sameperiodsperiod in2002. This reflects2003 primarily because of lower current year accruals for incentivefees payablefees. This reflects lower earnings during the current quarter due primarily tomanagementlower financing spreads andFortress primarily because of the recent trend of lower quarterly earningsno current period gains on asset sales anddividends (see "Financial Condition -- Management Changes").CMO redemptions, as described above.LIQUIDITY AND CAPITAL RESOURCES
Capstead'sCapstead’s primary sources of funds are borrowings under repurchase arrangements and monthly principal and interest payments on mortgage securities and similar investments. Other sources of funds include proceeds from other borrowing arrangements, proceeds from asset sales, unrestricted payments received on real estate held for lease and
excess cash flows on CMO collateral and investments.proceeds from equity offerings. The Company generally uses its liquidity to pay down borrowings under repurchase arrangements to reduce borrowingcosts.costs and otherwise efficiently manage its capital. Because the level of these borrowings can be adjusted on a daily basis, the level of unrestricted cash and cash equivalents carried on the balance sheet is less important than the Company’s potential liquidity available under its borrowing arrangements. The table included under"Financial“Financial Condition--— Utilization of Capital and PotentialLiquidity"Liquidity” and accompanying discussion illustrates additional funds potentially available to the Company as ofSeptember 30, 2003.March 31, 2004, as adjusted for liquidity reserves. The Company currently believes that it has ample liquidity and capital resources available for the acquisition of additional investments, repayments on borrowings and the payment of cash dividends as required forCapstead'sCapstead’s continued qualification as a REIT. It is theCompany'sCompany’s policy to remain strongly capitalized and conservatively leveraged.Borrowings under repurchase arrangements secured by Agency Securities and Non-agency Securities generally have maturities of less than 31
days.days, although from time to time the Company may enter into longer-term arrangements. These borrowings totaledapproximately $1.9$2.1 billion atSeptember 30, 2003.March 31, 2004. Capstead has uncommitted repurchase facilities with investment banking firms to finance these investments, subject to certain conditions. Interest rates on these borrowings are generally based on 30-day London Interbank Offered Rate("LIBOR"(“LIBOR”)rates(or a corresponding benchmark rate for longer-term arrangements) and related terms and conditions are negotiated on a transaction-by-transaction basis. Amounts available to be borrowed under these arrangements are dependent upon the fair value of the securities pledged as collateral, which fluctuates with changes in interest rates, credit quality and liquidity conditions within the investment banking, mortgage finance and real estateindustries (see "Effects of Interest Rate Changes").industries.Borrowings under repurchase arrangements with investment banking firms secured by CMBS
and from commercial banks secured by investments in commercial loansmore closely match the interest rate adjustment features of these investments such that the Company anticipates it can earn more consistent financing spreads and, as a result, experience less interest rate volatility than experienced with investments in Agency Securities. These borrowings, which generally have longer initial maturities than borrowings secured by Agency Securities and may feature renewal options, totaledapproximately $95$69 million atSeptember 30, 2003.March 31, 2004. Should Capstead make significant additional investments incredit- -23-sensitivecredit-sensitive assets, itis anticipated that it willmay attempt to lessen interest rate volatility in a similar fashion or through the use of derivative financial instruments("Derivatives"(“Derivatives”) such as interest rateswaps (see "Effects of Interest Rate Changes" and "Risks Associated With Credit-Sensitive Investments").swaps.CMO borrowings totaled
approximately $240$129 million atSeptember 30, 2003March 31, 2004 and are secured by CMO collateral pledged to the related indentures. As such, recourse is limited to this collateral and therefore has a limited impact onCapstead'sCapstead’s liquidity and capital resources.TheMortgage prepayments and Clean-up Calls affect the maturity of each CMOseries is affected by mortgage prepayments and clean-up calls.series.With its acquisition of senior living properties in May 2002, Capstead assumed
approximately$19 million in fixed-rate mortgage financing from a commercial bank that matures in 2009 and $101 million in tax-exempt bond debt. In November 2002, the tax-exempt bonds were refunded with proceeds from issuing new 30-year-23-
adjustable-rate tax-exempt bonds. Under the terms of the Lease, changes in interest rates on this debt are the responsibility of the lessee and as such, have
noa limited effect on theCompany'sCompany’s liquidity.Beginning in February 2004 the Company began selling common shares into the open market on a limited basis and such sales may resume during the second quarter. The proceeds from future issuances, if any, together with Capstead’s existing liquidity,
(see "Financial Condition -- Real Estate Held For Lease").are available to fund further acquisitions of ARM securities, if available at attractive prices, and increase the Company’s flexibility in pursuing real estate-related opportunities.EFFECTS OF INTEREST RATE CHANGES
INTEREST RATE SENSITIVITY ON OPERATING RESULTSInterest Rate Sensitivity on Operating Results
Capstead performs earnings sensitivity analysis using an income simulation model to estimate the effects that specific interest rate changes can reasonably be expected to have on future earnings. All financial assets and Derivatives held are included in this analysis. The sensitivity of components ofOther revenue (expense)to changes in interest rates is included as well, although no asset sales are assumed. Because under the terms of the Lease
Brookdalethe lessee is responsible for changes in related debt service requirements, earnings from theCompany'sCompany’s investment in net-leased real estate are generally not affected by changes in interest rates. The model incorporates management assumptions regarding the level of mortgage prepayments for a given interest rate change using market-based estimates of prepayment speeds for purposes of amortizing investment and liability premiums and discounts. These assumptions are developed through a combination of historical analysis and future expected pricing behavior.As of September 30, 2003,Capstead had the following estimated earnings sensitivity profile as of March 31, 2004 and December 31, 2003, respectively (dollars in thousands):
10-year 30-day U.S. LIBOR Treasury Rate Rate Immediate Change In:* 30-day LIBOR rate Flat Up 1.00% Up 1.00% Up 2.00% 10-year U.S. Treasury rate Down 1.00% Flat Up 1.00% Up 2.00% Projected 12-month earnings change: March 31, 2004 1.09 % 3.84 % $ (1,240 ) $ (11,038 ) $ (10,409 ) $ (23,049 ) December 31, 2003 1.12 4.25 (1,674 ) (10,732 ) (10,018 ) (21,713 )
10-YEAR 30-DAY U.S. LIBOR TREASURY RATE RATE IMMEDIATE CHANGE IN:* ---------- ---------- ------------------------------------------------------30-day LIBOR rate Down 1.00% Down 1.00% Flat Up 1.00% 10-year U.S. Treasury rate Down 1.00% Flat Up 1.00% Up 1.00% ProjectedSensitivity of earnings to changes in interest rates is determined relative to the actual rates at the applicable date. Note that the projected 12-month earnings change: September 30, 2003 1.12% 3.94% $7,491 $10,517 $2,172 $(9,143) December 31, 2002 1.38 3.82 8,484 11,817 2,490 (9,665)change is predicated on acquisitions of similar assets sufficient to replace runoff. There can be no guarantee that suitable investments will be available for purchase at attractive prices or if investments made will behave in the same fashion as assets currently held.* Sensitivity of earnings to changes in interest rates is determined relative to the actual rates at the applicable date. Note that the projected 12-month earnings change is predicated on acquisitions of similar assets sufficient to replace runoff. There can be no guarantee that suitable investments will be available for purchase at attractive prices or if investments made will behave in the same fashion as assets currently held.Income simulation modeling is the primary tool used to assess the direction and magnitude of changes in net margins on financial assets resulting from changes in interest rates. Key assumptions in the model include mortgage prepayment rates, changes in market conditions, and
management'smanagement’s financial capital plans. These assumptions are inherently uncertain and,as a result,therefore, the model cannot precisely estimate-24-net margins or precisely predict the impact of higher or lower interest rates on net margins. Actual results will differ from simulated results due to timing, magnitude and frequency of interest rate changes and other changes in market conditions, management strategies and other factors. GENERAL DISCUSSION OF EFFECTS OF INTEREST RATE CHANGES-24-
General Discussion of Effects of Interest Rate Changes
Changes in interest rates may affect
Capstead'sCapstead’s earnings in various ways. Earnings currently depend, in part, on the difference between the interest received on mortgage securities and similar investments, and the interest paid on related borrowings, which are generally based on 30-day LIBOR. The resulting financing spread may be reduced or even turn negative in a rising short-term interest rate environment. Because the mortgage securities and similar investments portfolio consists primarily of ARM securities, the risk of rising short-term interest rates is offset to some extent by increases in the rates of interest earned on the underlying ARM loans, which resetperiodicallyonce or twice a year based on underlying indices,(generally one-year CMT rates).subject to periodic and lifetime limits, referred to as caps. The Company’s ARM securities featured the following average coupon rate, and average periodic and lifetime caps as of March 31, 2004 (dollars in thousands):
Average Average Average ARM Type Basis * Coupon Rate Periodic Cap Lifetime Cap Agency Securities: Fannie Mae/Freddie Mac $ 1,295,186 3.56 % 1.744 % 11.239 % Ginnie Mae 839,714 4.17 1.000 10.373 Non-agency Securities 72,521 4.01 1.727 11.243
$ 2,207,421 3.81 1.460 10.910
* Basis represents the Company’s investment before unrealized gains and losses. Since only a portion of the ARM loans underlying these securities reset each month subject to periodic and
the terms of an ARM loan generally limit the amount of such increases during any single interest rate adjustment period and over the life of the loan,lifetime caps, interest rates on borrowings can rise to levels that may exceed the interest rates on the underlying loans, contributing to lower or even negative financing spreads. At other times, declines in these indices during periods of relatively low short-term interest rates will negatively effect yields on ARM securities as the underlying ARM loans reset at lower rates. If declines in these indices exceed declines in theCompany'sCompany’s borrowing rates, earningscouldwould be adversely affected. The Company may extend maturity dates on a portion of its short-term borrowings or invest in Derivatives from time to time as a hedge against rising interestrates on a portion of its short-term borrowings. At September 30, 2003,rates. Subsequent to quarter-end, the Companydidentered into several longer maturity repurchase arrangements totaling $200 million with maturities ranging from one and one-half to two years. As of April 30, 2004, the Company does not own any Derivatives for this purpose.Another effect of changes in interest rates is that as long-term interest rates decrease, the rate of principal prepayments on mortgage loans underlying mortgage securities and similar investments generally increases. During periods of relatively low interest rates, prolonged periods of high prepayments can significantly reduce the expected life of these investments; therefore, the actual yields realized can be lower due to faster amortization of premiums. Further, to the extent the proceeds of prepayments are not reinvested or cannot be reinvested at a rate of
interestreturn at least equal to the rate previously earned on that capital, earnings may be adversely affected. There can be no assurance that suitable investments at attractive pricing will be available on a timely basis to replace runoff as it occurs or that the current composition of investments (consisting primarily of ARM Agency Securities) will be maintained.A change in interest rates also impacts earnings recognized from CMO collateral and investments, which currently consist primarily of fixed-rate CMO residuals. During periods of relatively low mortgage interest rates, prepayments on the underlying mortgage loans generally will be higher, accelerating the amortization of collateral and bond premiums. Conversely, if mortgage interest rates rise significantly above interest rates on the collateral, principal prepayments will typically diminish, improving the overall return on an investment in a fixed-rate CMO residual because of an increase in time over which the Company receives positive net cash flows and can amortize remaining collateral and bond premiums.Capstead periodically sells assets, which may increase income volatility because of the recognition of transactional gains or losses. Such sales may become attractive as asset values fluctuate with changes in interest rates. At other times, asset sales may become prudent to shift the
Company'sCompany’s investment focus. During periods of rising interest rates or contracting market liquidity, asset values can decline, leading to increased margin calls and reducing theCompany'sCompany’s liquidity. A margin call means that a lender requires a borrower to pledge additional collateral to re-establish the agreed-upon ratio of the value of the collateral to the amount of the borrowing. If the Company is unable or unwilling to pledge additional collateral, lenders can liquidate the collateral under adverse market conditions, likely resulting in losses.-25-
RISKS ASSOCIATED WITH CREDIT-SENSITIVE INVESTMENTS
Commercial mortgage assets may be viewed as exposing an investor to greater risk of loss than residential mortgage assets since such assets are typically secured by larger loans to fewer obligors than residential mortgage assets. Commercial property values and related net operating income are often subject to volatility, and net operating income may be sufficient or insufficient to cover debt service on the related mortgage loan at any given time. The repayment of loans secured by income-producing properties is typically dependent upon the successful operation of the related real estate project and the ability of the applicable property to produce net operating income rather than upon the liquidation value of the underlying real estate. Even when the current net operating income is sufficient to cover debt service, there can be no assurance that this will continue to be the case in the future.
Additionally, commercial properties may not be readily convertible to alternative uses if such properties were to become unprofitable due to competition, age of improvements, decreased demand, regulatory changes or other factors. The conversion of commercial properties to alternate uses often requires substantial capital expenditures, which may or may not be available.
The availability of credit for commercial mortgage loans may be dependent upon economic conditions in the markets where such properties are located, as well as the willingness and ability of lenders to make such loans. The availability of funds in the credit markets fluctuates and there can be no assurance that the availability of such funds will increase above, or will not contract below current levels. In addition, the availability of similar commercial properties, and the competition for available credit, may affect the ability of potential purchasers to obtain financing for the acquisition of properties. This could effect the repayment of commercial mortgages.
Credit-sensitive residential mortgage assets differ from commercial mortgage assets in several important ways yet can still carry substantial credit risk. Residential mortgage securities typically are secured by smaller loans to more obligors than CMBS, thus spreading the risk of mortgagor default. However, most of the mortgages supporting credit-sensitive residential securities are made to homeowners that do not qualify for Agency loan programs for reasons including loan size, financial condition, or work or credit history that may be indicative of higher risk of default than loans qualifying for such programs. As with commercial mortgages, in instances of default the Company may incur losses if proceeds from sales of the underlying residential collateral are less than the unpaid principal balances of the residential mortgage loans and related foreclosure costs. However, with residential mortgages this risk may be mitigated by various forms of credit enhancements including, but not limited to, primary mortgage insurance.
Through the process of securitizing both commercial and residential mortgages, credit risk can be heightened or minimized. Senior classes in multi-class securitizations generally have first priority over cash flows from a pool of mortgages and, as a result, carry the least risk, highest investment ratings and the lowest yields. Typically, a securitization will also have mezzanine classes and subordinated classes. Mezzanine classes will generally have lower credit ratings, higher yields and may have average lives that are longer than the senior classes. Subordinate classes are junior in the right to receive cash flow from the underlying mortgages, thus providing credit enhancement to the senior and mezzanine classes. As a result, subordinated securities will have even lower credit ratings and higher yields because of the elevated risk of credit loss inherent in these securities.
The availability of capital from external sources to finance investments in credit-sensitive commercial and residential mortgage assets may be diminished during periods of mortgage finance market illiquidity. Additionally, if market conditions deteriorate resulting in substantial declines in value of these assets, sufficient capital may not be available to support the continued ownership of such investments, requiring these assets to be sold at a loss.
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RISKS ASSOCIATED WITH OWNING REAL ESTATE
The direct ownership of commercial real estate involves a number of risks. With its first acquisition of real estate, Capstead has attempted to mitigate these risks by entering into a long-term
"net-lease"“net-lease” arrangement whereby the lessee is responsible for the ongoing operation and management of the properties and for paying all expenses associated with the operation of the properties. Although reduced by this net-lease arrangement, risks of ownership remain, including:o The risk that changes in economic conditions or real estate markets may adversely affect the value of the properties. o During inflationary periods, which are generally accompanied by rising interest rates, increases in operating costs and borrowing rates may be greater than increases in lessee revenues from operating properties. Over an extended period of time, this could result in lessee defaults. o The risk that a deterioration of local conditions could adversely affect the ability of a lessee to profitably operate a property. For instance, an oversupply of senior living properties could hamper the leasing of senior living units at favorable rates. This could ultimately affect the value of the properties. o Changes in tax, zoning or other laws could make properties less attractive or less profitable. o An owner cannot be assured that lessees will elect to renew their leases when the terms expire. If a lessee does not renew its lease or otherwise defaults on its lease obligations, there is no assurance the owner can obtain a substitute lessee on acceptable terms. If the owner cannot obtain another qualified operator to lease a property, the owner may be required to modify the property for a different use, which may involve significant capital expenditures and delays in re-leasing the property. o The risk that lessees will not perform under their leases, reducing the owner's income from the leases or requiring the owner to assume costs (such as real estate taxes, insurance, utilities and maintenance) that are the lessees'
• The risk that changes in economic conditions or real estate markets may adversely affect the value of the properties. • During inflationary periods, which are generally accompanied by rising interest rates, increases in operating costs and borrowing rates may be greater than increases in lessee revenues from operating properties. Over an extended period of time, this could result in lessee defaults. • The risk that a deterioration of local conditions could adversely affect the ability of a lessee to profitably operate a property. For instance, an oversupply of senior living properties could hamper the leasing of senior living units at favorable rates. This could ultimately affect the value of the properties. • Changes in tax, zoning or other laws could make properties less attractive or less profitable. • An owner cannot be assured that lessees will elect to renew their leases when the terms expire. If a lessee does not renew its lease or otherwise defaults on its lease obligations, there is no assurance the owner can obtain a substitute lessee on acceptable terms. If the owner cannot obtain another qualified operator to lease a property, the owner may be required to modify the property for a different use, which may involve significant capital expenditures and delays in re-leasing the property. • The risk that lessees will not perform under their leases, reducing the owner’s income from the leases or requiring the owner to assume costs (such as real estate taxes, insurance, utilities and maintenance) that are the lessees’ responsibility under net-leases. In the case of special-purpose real estate such as senior living facilities, compliance with licensing requirements could complicate or delay the transfer of operational control of such properties. This could lead to a significant cash flow burden for the owner to service the debt and otherwise maintain the properties. o Net-leases generally require the lessee to carry comprehensive liability, casualty, workers' compensation and rental loss insurance. The required coverage is typical of the type, and amount, customarily obtained by an owner of similar properties. However, there are some types of losses, such as catastrophic acts of nature, for which insurance cannot be obtained at a commercially reasonable cost. If there is an uninsured loss or a loss in excess of insurance limits, the owner could lose both the revenues generated by the affected property and the capital invested in the property. The owner would, however, remain obligated to repay any mortgage indebtedness or other obligations related to the property. o Investments in real estate are subject to various federal, state and local regulatory requirements including the Americans with Disabilities Act (the "ADA"). The ADA requires that public accommodations reasonably accommodate individuals with disabilities and that new construction or alterations be made to commercial facilities to conform to accessibility guidelines. Failure to comply with the ADA can result in injunctions, fines, and damage awards to private parties and additional capital expenditures to remedy noncompliance. Existing requirements may change andcompliance with licensing requirements could complicate or delay the transfer of operational control of such properties. This could lead to a significant cash flow burden for the owner to service the debt and otherwise maintain the properties.• Net-leases generally require the lessee to carry comprehensive liability, casualty, workers’ compensation and rental loss insurance. The required coverage is typical of the type, and amount, customarily obtained by an owner of similar properties. However, there are some types of losses, such as catastrophic acts of nature, for which insurance cannot be obtained at a commercially reasonable cost. If there is an uninsured loss or a loss in excess of insurance limits, the owner could lose both the revenues generated by the affected property and the capital invested in the property. The owner would, however, remain obligated to repay any mortgage indebtedness or other obligations related to the property. • Investments in real estate are subject to various federal, state and local regulatory requirements including the Americans with Disabilities Act (the “ADA”). The ADA requires that public accommodations reasonably accommodate individuals with disabilities and that new construction or alterations be made to commercial facilities to conform to accessibility guidelines. Failure to comply with the ADA can result in injunctions, fines, and damage awards to private parties and additional capital expenditures to remedy noncompliance. Existing requirements may change and compliance -27-
with future requirements may involve significant unanticipated expenditures. Although typically these expenditures would be the responsibility of the lessee under the terms of net-leases, if lessees fail to perform these obligations, the owner may be required to do so. o Under federal, state and local environmental laws, the owner may be required to investigate and clean up any release of hazardous or toxic substances or petroleum products at its properties, regardless of its knowledge or actual responsibility, simply because of current or past ownership of the real estate. If unidentified environmental problems arise, the owner may have to make substantial payments, which could adversely affect cash flow and the ability to make distributions to stockholders. This is so because: 1. The owner may have to pay for property damage and for investigation and clean-up costs incurred in connection with the contamination. 2. The law may impose clean-up responsibility and liability regardless of whether the owner or operator knew of or caused the contamination. Even if more than one person is responsible for the contamination, each person who shares legal liability under environmental laws may be held responsible for all of the clean-up costs. 3. Governmental entities and third parties may sue the owner or operator of a contaminated site for damages and costs.
with future requirements may involve significant unanticipated expenditures. Although typically these expenditures would be the responsibility of the lessee under the terms of net-leases, if lessees fail to perform these obligations, the owner may be required to do so. • Under federal, state and local environmental laws, the owner may be required to investigate and clean up any release of hazardous or toxic substances or petroleum products at its properties, regardless of its knowledge or actual responsibility, simply because of current or past ownership of the real estate. If unidentified environmental problems arise, the owner may have to make substantial payments, which could adversely affect cash flow and the ability to make distributions to stockholders. This is so because:
1. The owner may have to pay for property damage and for investigation and clean-up costs incurred in connection with the contamination. 2. The law may impose clean-up responsibility and liability regardless of whether the owner or operator knew of or caused the contamination. Even if more than one person is responsible for the contamination, each person who shares legal liability under environmental laws may be held responsible for all of the clean-up costs. 3. Governmental entities and third parties may sue the owner or operator of a contaminated site for damages and costs. In investigating the acquisition of real estate, environmental studies are typically performed to establish the existence of any contamination. In addition, net-leases generally require lessees to operate properties in compliance with environmental laws and to indemnify the owner against environmental liability arising from the operation of such properties.
oAn owner may desire to sell a property in the future because of changes in market conditions or poor lessee performance or to avail itself of other opportunities. An owner may also be required to sell a property in the future to meet debt obligations or avoid a default. Unlike investments in mortgage securities, real estate cannot always be sold quickly, and there can be no assurance that the properties can be sold at a favorable price or that a prospective buyer will view existing lease or operating arrangements favorably. In addition, a property may require restoration or modification before it is sold.INVESTMENT COMPANY ACT OF 1940
The Investment Company Act of 1940, as amended (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. Capstead intends to conduct its business so as not to become regulated as an investment company under the Investment Company Act. If the Company fails to qualify for this exemption, its ability to use leverage would be substantially reduced and it would be unable to conduct its business as described herein.
Under the current interpretation of the staff of the Securities and Exchange Commission (“SEC”), in order to qualify for this exemption a REIT must maintain at least 55% of its assets directly in qualifying real estate interests. Mortgage-backed securities that do not represent all of the certificates issued with respect to an underlying pool of mortgages (“Non-whole Pool Securities”) may be treated as separate from the underlying mortgage loans and, thus, may not qualify for purposes of the 55% requirement. Therefore, the provisions of the Investment Company Act limit ownership of these mortgage-backed securities.
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In satisfying the 55% requirement under the Investment Company Act, a REIT may treat mortgage-backed securities issued with respect to an underlying pool to which it holds all issued certificates (“Whole Pool Securities”) as qualifying real estate interests. If the SEC or its staff adopts a contrary interpretation of such treatment, the REIT could be required to sell a substantial amount of Non-whole Pool Securities or other non-qualified assets under potentially adverse market conditions. Further, in order to ensure continued qualification for the exemption under the Investment Company Act, a REIT might be precluded from acquiring Non-whole Pool Securities even if their yield is higher than the yield of Whole Pool Securities. These factors may lower earnings.
CRITICAL ACCOUNTING POLICIES
AND ESTIMATES Management'sManagement’s discussion and analysis of financial condition and results of operations is based upon
Capstead'sCapstead’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires the use of estimates and judgments that can affect the reported amounts of assets, liabilities (including contingencies), revenues and expenses as well as related disclosures. These estimates are based on available internal and market information and appropriate valuation methodologies believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the expected useful lives and carrying values of assets and liabilities which can materially affect the determination of net income and book value per common share. Actual results may differ from these estimates under different assumptions or conditions.Management believes the following are critical accounting policies in the preparation of
Capstead'sCapstead’s consolidated financial statements that involve the use of estimates requiring considerable judgment:o Amortization of Premiums and Discounts on Financial Assets and Borrowings -- Premiums and discounts on financial assets and borrowings are recognized in earnings as adjustments to interest income or interest expense by the interest method over the estimated lives of the related assets or -28-borrowings. For most of Capstead's financial assets, and for its CMO borrowings, estimates and judgments related to future levels of mortgage prepayments are critical to this determination (see "Effects of Interest Rate Changes"). o Fair Value and Impairment Accounting for Financial Assets -- Most of Capstead's mortgage securities and similar investments portfolio and a small portion of its CMO collateral and investments portfolio are classified as held available-for-sale and recorded at fair value on the balance sheet with unrealized gains and losses recorded in stockholders' equity as a component of Accumulated other comprehensive income. As such, these unrealized gains and losses enter into the calculation of book value per common share. Generally, gains or losses are recognized in earnings only if sold; however, if a decline in fair value of an individual asset below its amortized cost occurs that is determined to be other than temporary, the difference between amortized cost and fair value would be included in Other revenue (expense) as an impairment charge. Considerable judgment is required interpreting market data to develop estimated fair values, particularly in circumstances of deteriorating credit quality and market liquidity (see "NOTE 10" to the accompanying consolidated financial statements for discussion of how Capstead values its financial assets, "Risks of Interest Rate Changes" and "Risks Associated with Credit-Sensitive Investments"). o Depreciation and Impairment Accounting for Real Estate held for Lease -- Real estate is carried at cost less accumulated depreciation. Depreciation is provided using the straight-line method over the estimated useful lives of buildings, equipment and fixtures. If a significant adverse event or change in circumstances occurs, management would assess if the values of the Company's real estate properties have become impaired. If estimated operating cash flows (undiscounted and without interest charges) of a property over its remaining useful life are less than its net carrying value, the difference between net carrying value and fair value would be included in Other revenue (expense) as an impairment charge. Considerable judgment is required in determining useful lives of components of real estate properties and in estimating operating cash flows, particularly during periods of changing circumstances (see "Risks Associated with Owning Real Estate"
• Amortization of Premiums and Discounts on Financial Assets and Borrowings— Premiums and discounts on financial assets and borrowings are recognized in earnings as adjustments to interest income or interest expense by the interest method over the estimated lives of the related assets or borrowings. For most of Capstead’s financial assets, and for its CMO borrowings, estimates and judgments related to future levels of mortgage prepayments are critical to this determination (see “Effects of Interest Rate Changes”). • Fair Value and Impairment Accounting for Financial Assets— Most of Capstead’s mortgage securities and similar investments portfolio and a small portion of its CMO collateral and investments portfolio are classified as held available-for-sale and recorded at fair value on the balance sheet with unrealized gains and losses recorded in stockholders’ equity as a component ofAccumulated other comprehensive income. As such, these unrealized gains and losses enter into the calculation of book value per common share. Generally, gains or losses are recognized in earnings only if sold; however, if a decline in fair value of an individual asset below its amortized cost occurs that is determined to be other than temporary, the difference between amortized cost and fair value would be included inOther revenue (expense)as an impairment charge. Considerable judgment is required interpreting market data to develop estimated fair values, particularly in circumstances of deteriorating credit quality and market liquidity (see “NOTE 10” to the accompanying consolidated financial statements for discussion of how Capstead values its financial assets, “Risks of Interest Rate Changes” and “Risks Associated with Credit-Sensitive Investments”). • Depreciation and Impairment Accounting for Real Estate held for Lease— Real estate is carried on the Company’s balance sheet at cost less accumulated depreciation. Depreciation is provided using the straight-line method over the estimated useful lives of buildings, equipment and fixtures. If a significant adverse event or change in circumstances occurs, management would assess if the values of the Company’s real estate properties have become impaired. If estimated operating cash flows -29-
(undiscounted and without interest charges) of a property over its remaining useful life are less than its net carrying value, the difference between net carrying value and fair value would be included inOther revenue (expense) as an impairment charge. Considerable judgment is required in determining useful lives of components of real estate properties and in estimating operating cash flows, particularly during periods of changing circumstances (see “Risks Associated with Owning Real Estate”). FORWARD LOOKING STATEMENTS
This document contains
"forward-looking statements"“forward-looking statements” (within the meaning of the Private Securities Litigation Reform Act of 1995) that inherently involve risks and uncertainties.Capstead'sCapstead’s actual results and liquidity can differ materially from those anticipated in these forward-looking statements because of changes in the level and composition of theCompany'sCompany’s investments and unforeseen factors. Relative to theCompany'sCompany’s investments in financial assets, these factors may include, but are not limited to, changes in general economic conditions, the availability of suitable qualifying investments from both an investment return and regulatory perspective, fluctuations in, and market expectations for fluctuations in, interest rates and levels of mortgage prepayments, deterioration in credit quality and ratings, the effectiveness of risk management strategies, the impact of leverage, liquidity of secondary markets and credit markets, increases in costs and other general competitive factors. Relative to direct investments in real estate, these factors may include, but are not limited to, lessee performance under lease agreements, changes in general as well as local economic conditions and real estate markets, increases in competition and inflationary pressures, changes in the tax and regulatory environment including zoning and environmental laws, uninsured losses or losses in excess of insurance limits and the availability of adequate insurance coverage at reasonable costs.-29-COMPARISON OF OPERATING INCOME AND DILUTED INCOME PER
COMMONSHAREThe following table
reconciles net income to operating income andcompares the calculation of operating income and operating income per common share to net income and diluted net income per share (in thousands, except per share amounts):
QUARTER ENDED --------------------------------------------------------------------------- SEPTEMBER 30, 2003 JUNE 30, 2003 SEPTEMBER 30, 2002 ---------------------- ---------------------- ---------------------- OPERATING DILUTED OPERATING DILUTED OPERATING DILUTED --------- -------- --------- -------- --------- --------Net income $ 14,779 $ 14,779 $ 15,241 $ 15,241 $ 22,751 $ 22,751 Adjustments for: Depreciation on real estate 927 -- 927 -- 962 -- Gain on asset sales and CMO redemptions (1,411) -- (1,393) -- (1,901) -- Series B preferred dividends (4,982) -- (4,982) -- (4,990) -- -------- -------- -------- -------- -------- -------- $ 9,313 $ 14,779 $ 9,793 $ 15,241 $ 16,822 $ 22,751 ======== ======== ======== ======== ======== ======== Weighted average common shares outstanding 13,995 13,995 13,978 13,978 13,871 13,871 Net effect of dilutive securities: Preferred B shares -- 8,987 -- 8,943 -- 5,638 Stock options and other preferred shares 353 353 349 349 310 310 -------- -------- -------- -------- -------- -------- 14,348 23,335 14,327 23,270 14,181 19,819 ======== ======== ======== ======== ======== ======== $ 0.65 $ 0.63 $ 0.68 $ 0.65 $ 1.19 $ 1.15 ======== ======== ======== ======== ======== ========
NINE MONTHS ENDED ------------------------------------------------- SEPTEMBER 30, 2003 SEPTEMBER 30, 2002 ---------------------- ---------------------- OPERATING DILUTED OPERATING DILUTED --------- -------- --------- --------Net income $ 47,563 $ 47,563 $ 75,712 $ 75,712 Adjustments for: Depreciation on real estate 2,781 -- 1,604 -- Gain on asset sales and CMO redemptions (4,551) -- (1,901) -- Series B preferred dividends (14,948) -- (14,970) -- -------- -------- -------- -------- $ 30,845 $ 47,563 $ 60,445 $ 75,712 ======== ======== ======== ======== Weighted average common shares outstanding 13,969 13,969 13,850 13,850 Net effect of dilutive securities: Preferred B shares -- 8,947 -- 5,639 Stock options and other preferred shares 351 351 320 320 -------- -------- -------- -------- 14,320 23,267 14,170 19,809 ======== ======== ======== ======== $ 2.15 $ 2.04 $ 4.27 $ 3.82 ======== ======== ======== ========
Quarter Ended March 31, 2004 March 31, 2003 Operating Diluted Operating Diluted Net income $ 12,354 $ 12,354 $ 17,543 $ 17,543 Adjustments for: Depreciation on real estate 927 — 927 — Gain on asset sales and CMO redemptions — — (1,748 ) — Series B preferred dividends (4,983 ) (4,983 ) (4,983 ) —
$ 8,298 $ 7,371 $ 11,739 $ 17,543
Weighted average common shares outstanding 14,267 14,267 13,935 13,935 Net effect of dilutive securities: Preferred B shares — — — 8,910 Stock options and other preferred shares 353 353 407 407
14,620 14,620 14,342 23,252
$ 0.57 $ 0.50 $ 0.82 $ 0.75
-30-
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE OF MARKET RISKS
The information required by this Item is incorporated by reference to the information included in Item 2.
"Management's“Management’s Discussion and Analysis of Financial Condition and Results of Operations."”ITEM 4. CONTROLS AND PROCEDURES
As of
September 30, 2003,March 31, 2004, an evaluation was performed under the supervision and with the participation of theCompany'sCompany’s management, including theChief Executive Officer ("CEO")CEO and Chief Financial Officer("CFO"(“CFO”), of the effectiveness of the design and operation of theCompany'sCompany’s disclosure controls and procedures. Based on that evaluation, theCompany'sCompany’s management, including the CEO and CFO, concluded that theCompany'sCompany’s disclosure controls and procedures were effective as ofSeptember 30, 2003.March 31, 2004. There have been no significant changes in theCompany'sCompany’s internal controls or in other factors that could significantly affect internal controls subsequent toSeptember 30, 2003.March 31, 2004.PART II.
--— OTHER INFORMATIONITEM
1. LEGAL PROCEEDINGS The information required by this item is included in NOTE 13 to the accompanying unaudited interim financial statements and is incorporated herein by reference.4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
(a) The annual meeting of stockholders was held April 22, 2004. (b) The board members included in (c) below were elected to Capstead’s Board of Directors (constituting the entire Board of Directors). (c) The following items were voted on at the annual meeting:
Withheld/ Broker For Against Abstentions Non-votes • Election of board members: Andrew F. Jacobs 13,301,700 — 335,707 — Gary Keiser 13,255,364 — 382,043 — Paul M. Low 13,272,371 — 365,036 — Michael G. O'Neil 13,314,001 — 232,406 — Howard Rubin 13,268,906 — 368,501 — Mark S. Whiting 13,273,947 — 363,460 — • Ratify Appointment of Ernst & Young LLP as Independent Auditors 13,351,845 145,670 139,692 — • Approval of the 2004 Flexible Long-Term Incentive Plan 5,524,979 1,483,808 360,307 6,268,313 • Other matters (no other matters) -31-
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits: The following Exhibits are presented herewith: Exhibit 12 -- Computation of Ratio of Earnings to Combined Fixed Charges and Preferred Stock Dividends. Exhibit 31.1 -- Certification pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002. Exhibit 32.1 -- Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (b) Reports on Form 8-K: Current Report on Form 8-K dated July 22, 2003 announcing second quarter 2003 financial results and management changes at Capstead. -31-
(a) Exhibits: The following Exhibits are presented herewith: Exhibit 12 — Computation of Ratio of Earnings to Combined Fixed Charges and Preferred Stock Dividends. Exhibit 31.1 — Certification pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002 Exhibit 31.2 — Certification pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002 Exhibit 32 — Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (b) Reports on Form 8-K: Current Report on Form 8-K dated January 28, 2004 announcing fourth quarter 2003 financial results, record date for Annual Meeting of Stockholders and common dividend schedule for 2004. Current Report on Form 8-K dated April 22, 2004 announcing first quarter 2004 financial results. SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the
RegistrantCompany has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.CAPSTEAD MORTGAGE CORPORATION Date: November 5, 2003 By: /s/ ANDREW F. JACOBS ----------------------------------- Andrew F. Jacobs President and Chief Executive Officer Date: November 5, 2003 By: /s/ PHILLIP A. REINSCH ----------------------------------- Phillip A. Reinsch Senior Vice
CAPSTEAD MORTGAGE CORPORATION
RegistrantDate: May 4, 2004 By: /s/ ANDREW F. JACOBS Andrew F. Jacobs President and Chief Executive Officer
Date: May 4, 2004 By: /s/ PHILLIP A. REINSCH Phillip A. Reinsch Senior Vice President and
Chief Financial Officer-32-