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CMO > SEC Filings for CMO > Form 10-Q on 2-Nov-2012All Recent SEC Filings

Show all filings for CAPSTEAD MORTGAGE CORP | Request a Trial to NEW EDGAR Online Pro

Form 10-Q for CAPSTEAD MORTGAGE CORP


2-Nov-2012

Quarterly Report


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

FINANCIAL CONDITION

Overview

Capstead Mortgage Corporation operates as a self-managed real estate investment trust for federal income tax purposes (a "REIT") and is based in Dallas, Texas. Unless the context otherwise indicates, Capstead Mortgage Corporation, together with its subsidiaries, is referred to as "Capstead" or the "Company." Capstead earns income from investing in a leveraged portfolio of residential mortgage pass-through securities consisting almost exclusively of adjustable-rate mortgage ("ARM") securities issued and guaranteed by government-sponsored enterprises, either Fannie Mae or Freddie Mac (together, the "GSEs"), or by an agency of the federal government, Ginnie Mae. Agency-guaranteed mortgage securities ("Agency Securities") are considered to have limited, if any, credit risk.

Capstead's investment strategy involves managing a conservatively leveraged portfolio of ARM Agency Securities that can produce attractive risk-adjusted returns over the long term, while reducing, but not eliminating, sensitivity to changes in interest rates. This strategy differentiates the Company from its peers because ARM Agency Securities reset to more current interest rates within a relatively short period of time allowing for (a) the recovery of financing spreads diminished during periods of rising interest rates and (b) smaller fluctuations in portfolio values from changes in interest rates compared to portfolios that contain a significant amount of fixed-rate Agency Securities. From a credit-risk perspective, the credit quality of Agency Securities helps ensure that fluctuations in value due to credit risk should be limited and financing at reasonable rates and terms is more likely to remain available under stressed market conditions.

Capstead finances its investments with borrowings under repurchase arrangements with commercial banks and other financial institutions supported by its long-term investment capital, which as of September 30, 2012 totaled $1.66 billion and consisted of $1.37 billion of common and $189 million of perpetual preferred stockholders' equity (recorded amounts) and $100 million of long-term unsecured borrowings (net of related investments in statutory trusts). Long-term investment capital increased by $271 million or 19% during the nine months ended September 30, 2012 primarily as a result of raising $142 million in common equity capital and higher portfolio pricing levels. Holdings of ARM Agency Securities increased by $2.05 billion or 17% in 2012, to $14.31 billion at September 30, 2012, while repurchase arrangements and similar borrowings increased $1.90 billion or 17% in 2012 to $13.25 billion. Portfolio leverage (repurchase arrangements and similar borrowings divided by long-term investment capital) decreased modestly to 7.96 to one by September 30, 2012 from 8.15 to one at December 31, 2011. Management believes borrowing at current levels represents an appropriate and prudent use of leverage for a portfolio of Agency Securities under current market conditions, particularly a portfolio consisting almost entirely of short-duration ARM Agency Securities (duration is a common measure of market price sensitivity to interest rate movements). Provided capital can continue to be deployed at attractive levels and financing conditions remain favorable, management anticipates maintaining portfolio leverage near September 30, 2012 levels.

Capstead reported net income of $40 million and $129 million or $0.35 and $1.20 per diluted common share for the quarter and nine months ended September 30, 2012, respectively, compared to $41 million and $118 million or $0.43 and $1.32 per diluted common share for the same periods in 2011. Financing spreads on residential mortgage investments averaged 130 and 148 basis points for the quarter and nine months ended September 30, 2012, respectively, compared to 160 and 172 basis points during the same periods in 2011. Financing spreads on residential mortgage investments is a non-GAAP financial measure based solely on yields on the Company's residential mortgage investments, net of borrowing rates on repurchase arrangements and similar borrowings, adjusted for currently-paying interest rate swap

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agreements held for hedging purposes. This measure differs from total financing spreads, an all-inclusive GAAP measure, that is based on all interest-bearing assets and all interest-paying liabilities - see page 26 of this filing for a reconciliation of these measures. Lower financing spreads during 2012 reflect
(a) lower cash yields on the portfolio because of the effects of ARM loan coupon interest rates underlying the portfolio resetting lower to more current rates and lower coupon interest rates on acquisitions, and (b) higher investment premium amortization primarily because of higher portfolio runoff as well as higher prices paid for portfolio acquisitions in recent years. The effect on financing spreads of lower portfolio yields was only partially offset by lower borrowing rates as the benefits of replacing higher cost interest rate swap agreements as these contracts expired with additional two-year term swap agreements at more favorable rates have been largely offset by increases in unhedged borrowing rates in recent quarters due to a variety of market factors.

The size and composition of Capstead's investment portfolio depends on investment strategies being implemented by management, as well as overall market conditions, including the availability of attractively priced investments and suitable financing to appropriately leverage the Company's investment capital. Market conditions are influenced by, among other things, current levels of, and expectations for future levels of, short-term interest rates, mortgage prepayments and market liquidity.

Risk Factors and Critical Accounting Policies

Under the captions "Risk Factors" and "Critical Accounting Policies" are discussions of risk factors and critical accounting policies affecting Capstead's financial condition and earnings that are an integral part of this discussion and analysis. Readers are strongly urged to consider the potential impact of these factors and accounting policies on the Company and its financial results.

Equity Capital Issuances and Recently Announced Common Stock Repurchase Program

During the third quarter of 2012 Capstead raised $21 million in new common equity capital, after underwriting discounts and offering expenses, by issuing 1.5 million common shares at an average price of $13.93 per share, after expenses, through the Company's at-the-market, continuous offering program. No shares were issued under this program subsequent to quarter-end. Year-to-date the Company has raised $142 million by issuing 10.5 million common shares at an average price of $13.52 per share under this program. Additionally, during the first and second quarters of 2012 the Company raised $4 million by issuing 309,000 Series B preferred shares at an average price of $14.50 per share under this program. As of quarter-end, 6.4 million common shares and 1.3 million Series B preferred shares are available for issuance under this program pursuant to supplements filed with the applicable registration statement on file with the Securities and Exchange Commission (the "SEC").

The Company suspended its continuous offering program in connection with its October 30, 2012 announcement of a $100 million common stock repurchase program. Purchases made pursuant to the stock repurchase program will be made in the open market or through privately negotiated transactions from time to time as permitted by securities laws and other legal requirements. The timing, manner, price and amount of any repurchases will be determined by the Company in its discretion and will be subject to economic and market conditions, stock price, applicable legal requirements and other factors. The authorization does not obligate the Company to acquire any particular amount of common shares and the program may be suspended or discontinued at the Company's discretion without prior notice.

Book Value per Common Share

Nearly all of Capstead's residential mortgage investments and all of its interest rate swap agreements are reflected at fair value on the Company's balance sheet and included in the calculation of book value per common share (total stockholders' equity, less perpetual preferred share liquidation preferences, divided by common shares outstanding). The fair value of these investments is impacted by market conditions, including changes in interest rates, and the availability of financing at reasonable rates and leverage levels. The Company's investment strategy attempts to mitigate these risks by focusing on investments in

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Agency Securities, which are considered to have little, if any, credit risk and are collateralized by ARM loans with interest rates that reset periodically to more current levels. Because of these characteristics, the fair value of Capstead's portfolio is considerably less vulnerable to significant pricing declines caused by credit concerns or rising interest rates compared to portfolios containing a significant amount of non-agency and/or fixed-rate mortgage securities. The following table illustrates the progression of book value per common share for the quarter and nine months ended September 30, 2012:

                                                 Quarter Ended                 Nine Months Ended
                                              September 30, 2012              September 30, 2012
Book value per common share,
beginning of period                           $             13.23             $             12.52
Capital transactions:
Accretion from capital raises                                0.01                            0.11
Increase related to stock awards                               -                             0.01
Dividend distributions in excess of
earnings                                                    (0.01 )                         (0.02 )
Increase in fair value of mortgage
securities classified as
available-for-sale                                           0.68                            1.36
Increase (decrease) in fair value of
interest rate swap agreements
designated as cash flow hedges of:
Repurchase arrangements and similar
borrowings                                                  (0.05 )                         (0.09 )
Unsecured borrowings                                         0.02                           (0.01 )

Book value per common share, end of
period                                        $             13.88             $             13.88

Increase in book value per common
share during the indicated periods            $              0.65             $              1.36

Residential Mortgage Investments

Capstead's investment strategy focuses on managing a large portfolio of residential mortgage investments consisting almost exclusively of ARM Agency Securities. Agency Securities are considered to have limited, if any, credit risk because the timely payment of principal and interest is guaranteed by the GSEs, which are federally chartered corporations, or an agency of the federal government, Ginnie Mae. The 2008 conservatorship of the GSEs by their federal regulator, and related capital commitments to the GSEs made by the U.S. Treasury, have largely alleviated market concerns regarding the ability of the GSEs to fulfill their guarantee obligations. By focusing on investing in relatively short-duration ARM Agency Securities, declines in fair value caused by increases in interest rates are typically relatively modest compared to investments in longer-duration, fixed-rate assets. These declines can be recovered in a relatively short period of time as coupon interest rates on the underlying mortgage loans reset to rates more reflective of the then current interest rate environment allowing for the potential recovery of financing spreads diminished during periods of rising interest rates. The following table illustrates the progression of Capstead's portfolio of residential mortgage investments for the quarter and nine months ended September 30, 2012 (in thousands):

                                                 Quarter Ended               Nine Months Ended
                                               September 30, 2012            September 30, 2012
Residential mortgage investments,
beginning of period                           $         13,799,487          $         12,264,906
Increase in unrealized gains on
mortgage securities classified as
available-for-sale                                          66,910                       134,583
Portfolio acquisitions (principal
amount) at average lifetime purchased
yields of 2.01% and 2.20%                                1,197,496                     3,778,048
Investment premiums on acquisitions                         53,866                       158,103
Portfolio runoff (principal amount)                       (777,400 )                  (1,955,086 )
Investment premium amortization                            (27,151 )                     (67,346 )

Residential mortgage investments, end
of period                                     $         14,313,208          $         14,313,208

Average carrying amount of residential
mortgage investments outstanding during
the indicated periods *                       $         13,989,176          $         13,250,676

* Includes unrealized gains and losses for residential mortgage investments classified as available-for-sale.

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ARM securities are backed by residential mortgage loans that have coupon interest rates that adjust at least annually to more current interest rates or begin doing so after an initial fixed-rate period. After the initial fixed-rate period, if applicable, mortgage loans underlying ARM securities either
(i) adjust annually based on specified margins over the one-year Constant Maturity U.S. Treasury Note Rate ("CMT") or the one-year London interbank offered rate ("LIBOR"), (ii) adjust semiannually based on specified margins over six-month LIBOR, or (iii) adjust monthly based on specified margins over indices such as one-month LIBOR, the Eleventh District Federal Reserve Bank Cost of Funds Index, or over a rolling twelve month average of the one-year CMT index, usually subject to periodic and lifetime limits, or caps, on the amount of such adjustments during any single interest rate adjustment period and over the contractual term of the underlying loans.

As of September 30, 2012, nearly all of Capstead's residential mortgage investments consisted of ARM Agency Securities and a small amount of adjustable-rate residential mortgage loans, featuring the following characteristics (dollars in thousands):

                                            Amortized                         Fully           Average           Average         Average          Months
                                               Cost            Net           Indexed            Net             Periodic        Lifetime           To
ARM Type (a)                                Basis (b)        WAC  (c)        WAC (c)        Margins  (c)        Caps (c)        Caps (c)        Roll (a)
Current-reset ARMs:
Fannie Mae Agency Securities               $  5,369,945           2.48 %         2.38 %              1.70 %          3.19 %         10.18 %           5.0
Freddie Mac Agency Securities                 1,945,619           2.83           2.52                1.84            2.08           10.66             6.2
Ginnie Mae Agency Securities                    745,926           2.46           1.70                1.51            1.02            9.32             6.6
Residential mortgage loans                        5,159           3.51           2.44                2.04            1.49           10.97             4.5

                                              8,066,649           2.56           2.35                1.71            2.73           10.21             5.4

Longer-to-reset ARMs:
Fannie Mae Agency Securities                  3,034,453           3.00           2.74                1.77            4.80            8.06            44.2
Freddie Mac Agency Securities                 1,900,797           2.97           2.80                1.84            4.91            8.00            49.8
Ginnie Mae Agency Securities                    932,652           3.04           1.69                1.51            1.02            8.07            32.6

                                              5,867,902           3.00           2.59                1.75            4.24            8.04            44.1

                                           $ 13,934,551           2.74           2.45                1.73            3.36            9.30            21.6

Gross WAC (rate paid by borrowers) (d)                            3.37

(a) Capstead classifies its ARM securities based on the average length of time until the loans underlying each security reset to more current rates ("months-to-roll") (less than 18 months for "current-reset" ARM securities, and 18 months or greater for "longer-to-reset" ARM securities). Once an ARM loan reaches its initial reset date, it will reset at least once a year to a margin over a corresponding interest rate index, subject to periodic and lifetime limits or caps.

(b) Amortized cost basis represents the Company's investment (unpaid principal balance plus unamortized investment premiums) before unrealized gains and losses. As of September 30, 2012, the ratio of amortized cost basis to related unpaid principal balance for the Company's ARM securities was 103.06. This table excludes $3 million in fixed-rate Agency Securities, $3 million in fixed-rate residential mortgage loans and $3 million in private residential mortgage pass-through securities held as collateral for structured financings.

(c) Net WAC, or weighted average coupon, is the weighted average interest rate of the mortgage loans underlying the indicated investments, net of servicing and other fees as of the indicated date. Net WAC is expressed as a percentage calculated on an annualized basis on the unpaid principal balances of the mortgage loans underlying these investments. Fully indexed WAC represents the weighted average coupon upon one or more resets using interest rate indexes and net margins as of the indicated date. Average net margins represent the weighted average levels over the underlying indexes that the portfolio can adjust to upon reset, usually subject to initial, periodic and/or lifetime limits, or caps, on the amount of such adjustments during any single interest rate adjustment period and over the contractual term of the underlying loans. ARM securities issued by the GSEs with initial fixed-rate periods of five years or longer typically have 500 basis point initial caps with 200 basis point periodic caps. Additionally, certain ARM securities held by the Company are subject only to lifetime caps or were not subject to a cap. For presentation purposes, average periodic caps in the table above reflect initial caps until after an ARM security has reached its initial reset date and lifetime caps, less the current net WAC, for ARM securities subject only to lifetime caps. At quarter-end, 80% of current-reset ARMs were subject to periodic caps averaging 1.85%; 4% were subject to initial caps averaging 2.42%; 15% were subject to lifetime caps, less the current net WAC, averaging 7.56%; and 1% were not subject to a cap. All longer-to-reset ARM securities at September 30, 2012 were subject to initial caps.

(d) Gross WAC is the weighted average interest rate of the mortgage loans underlying the indicated investments, including servicing and other fees paid by borrowers, as of the indicated balance sheet date.

After consideration of any applicable initial fixed-rate periods, at September 30, 2012 approximately 80%, 12% and 8% of the Company's ARM securities were backed by mortgage loans that reset annually, semi-annually and monthly. Approximately 96% of the Company's current-reset ARM securities have reached an initial coupon reset date, while none of its longer-to-reset ARM securities have reached an

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initial coupon reset date. Additionally, at September 30, 2012 approximately 18% of the Company's ARM securities were backed by interest-only loans that have not reached an initial coupon reset date. All percentages are approximate and based on averages of the characteristics of mortgage loans underlying each security and calculated using unpaid principal balances as of the indicated balance sheet date.

ARM Agency Securities typically are acquired at a premium to the securities' unpaid principal balances and high levels of mortgage prepayments can put downward pressure on yields and financing spreads because the level of mortgage prepayments impacts how quickly investment premiums are written off against earnings as portfolio yield adjustments. Portfolio runoff during the quarter and nine months ended September 30, 2012 averaged 21.1% and 18.8% on an annualized basis, respectively (a constant prepayment rate, or "CPR," of 18.7% and 16.4%, respectively). Higher portfolio runoff in the third quarter reflects seasonal prepayment patterns as well as lower prevailing mortgage interest rates available to consumers. While the current low interest rate environment can be expected to persist for some time, certain characteristics of the Company's portfolio are expected to lessen the risk of experiencing sharply higher prepayment levels. A key differentiating factor of Capstead's investment strategy relative to the strategies implemented by peers in the mortgage REIT sector is the Company's focus on investing solely in ARM securities. At September 30, 2012 the portfolio was backed by mortgages requiring borrowers to make payments predicated on rates averaging a relatively low 3.37%, of which 56% were originated prior to 2009. Mortgage prepayments on securities backed by more seasoned loans have been partially suppressed by low housing prices and credit problems being experienced by many of these borrowers, even as prepayments on newer originations have increased. As a result, many borrowers with mortgage loans underlying securities in the portfolio lack the ability to meaningfully lower their mortgage payments even if they can overcome all of these impediments to refinancing. For these reasons, management anticipates mortgage prepayments to remain at manageable levels.

Capstead generally pledges its residential mortgage investments as collateral under uncommitted repurchase arrangements, the terms and conditions of which are negotiated on a transaction-by-transaction basis with commercial banks and other financial institutions, referred to as counterparties, when each borrowing is initiated or renewed. None of the Company's counterparties are obligated to renew or otherwise enter into new repurchase transactions at the conclusion of existing repurchase transactions. Repurchase arrangements entered into by the Company involve the sale and a simultaneous agreement to repurchase the transferred assets at a future date, typically with terms of 30 to 90 days, and are accounted for as financings by the Company. The Company maintains the beneficial interest in the specific securities pledged during the term of the repurchase arrangement and receives the related principal and interest payments. The amount borrowed is generally equal to the fair value of the assets pledged, as determined by the lending counterparty, less an agreed-upon discount, referred to as a "haircut." Since early in 2009, haircut requirements for pledged Agency Securities have remained relatively stable and as of September 30, 2012, haircuts on outstanding borrowings averaged 4.5 percent and typically ranged from 3.0 to 5.0 percent of the fair value of the pledged securities. After considering related interest receivable, as well as interest payable on these borrowings, the Company had $706 million of capital at risk with its lending counterparties as of September 30, 2012.

Interest rates charged on repurchase arrangements and similar borrowings are fixed based on prevailing rates corresponding to the terms of the borrowings, and interest is paid at the termination of the repurchase arrangement at which time the Company may enter into a new repurchase arrangement at prevailing market rates with the same counterparty or repay that counterparty and negotiate financing with a different counterparty. When the fair value of pledged securities declines due to changes in market conditions or the publishing of monthly security pay down factors, lenders typically require the Company to post additional securities as collateral, pay down borrowings or establish cash margin accounts with the counterparties in order to re-establish the agreed-upon collateral requirements, referred to as margin calls. Conversely, if collateral fair values increase, lenders are required to release collateral back to the Company pursuant to Company-issued margin calls. The Company's borrowings under repurchase

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arrangements and similar borrowings at September 30, 2012 consisted of $13.25 billion of primarily 30-day borrowings with 24 counterparties at average rates of 0.41%, before the effects of interest rate swap agreements held as cash flow hedges on a designated portion of 30- to 90-day borrowings (see below) and 0.56% including the effects of these derivative financial instruments.

To help mitigate exposure to higher short-term interest rates, Capstead typically uses currently-paying and forward-starting, one-month LIBOR-indexed, pay-fixed, receive-variable, interest rate swap agreements that require interest payments for two-year terms. Variable payments received by the Company under these swap agreements largely offset interest accruing on a like amount of the Company's 30- to 90-day borrowings, leaving the fixed-rate payments to be paid on the swap agreements as the Company's effective borrowing rate, subject to certain adjustments. These adjustments include the effects of measured hedge ineffectiveness and changes in spreads between variable rates on the swap agreements and related actual borrowing rates. Under the terms of currently-paying interest rate swap agreements held at September 30, 2012, the Company is required to pay fixed rates of interest averaging 0.78% on notional amounts totaling $3.70 billion with average remaining interest payment terms of ten months. Additionally, as of quarter-end the Company had entered into forward-starting swap agreements with notional amounts totaling $2.30 billion that will begin requiring interest payments at fixed rates averaging 0.50% for two-year periods that commence on various dates between October 2012 and October 2013, with an average expiration of 29 months.

After consideration of all swap positions entered into as of quarter-end to hedge short-term borrowing rates, the Company's residential mortgage investments and related borrowings under repurchase arrangements had estimated durations at September 30, 2012 of 10 1/2 months and 8 months, respectively, for a net duration gap of 2 1/2 months. The Company intends to continue to manage interest rate risk associated with holding and financing its residential mortgage investments by utilizing suitable derivative financial instruments such as . . .

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