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CMO > SEC Filings for CMO > Form 10-Q on 9-May-2014All Recent SEC Filings

Show all filings for CAPSTEAD MORTGAGE CORP

Form 10-Q for CAPSTEAD MORTGAGE CORP


9-May-2014

Quarterly Report


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

FINANCIAL CONDITION

Overview

Capstead operates as a self-managed REIT and earns income from investing in a leveraged portfolio of residential mortgage pass-through securities consisting almost exclusively of short-duration ARM Agency Securities, which are considered to have limited, if any, credit risk and reset to more current interest rates within a relatively short period of time. This strategy of investing in ARM Agency Securities positions the Company to (a) benefit from potential recoveries in financing spreads that typically contract during periods of rising interest rates and (b) experience smaller fluctuations in portfolio values compared to portfolios containing a significant amount of longer-duration ARM or fixed-rate mortgage securities. Duration is a common measure of market price sensitivity to interest rate movements and a shorter duration generally indicates less interest rate risk.

Capstead finances its portfolio of ARM Agency Securities with borrowings under repurchase arrangements with commercial banks and other financial institutions supported by its long-term investment capital, which as of March 31, 2014 totaled $1.48 billion and consisted of $1.21 billion of common and $167 million of perpetual preferred stockholders' equity (recorded amount) and $100 million of unsecured borrowings that mature in 2035 and 2036. Long-term investment capital increased by $13 million during the quarter ended March 31, 2014 primarily as a result of higher portfolio pricing levels ($17 million), earnings in excess of dividend payments ($3 million) and Series E preferred capital raised using an at-the-market continuous offering program ($1 million), partially offset by lower pricing levels for interest rate swap agreements held for hedging purposes ($8 million).

The recorded value of Capstead's holdings of ARM Agency Securities increased by $53 million during the quarter to $13.53 billion at March 31, 2014, with portfolio acquisitions exceeding portfolio runoff by $34 million (principal amount) and the remainder primarily attributable to a 13.5 basis point increase in overall portfolio pricing levels. Borrowings under repurchase arrangements increased by $107 million during the quarter to $12.59 billion. Portfolio leverage (borrowings under repurchase arrangements divided by long-term investment capital) was unchanged from year-end at 8.52 to one at March 31, 2014. Management believes borrowing at current levels represents an appropriate and prudent use of leverage under current market conditions for a portfolio of seasoned, short-duration ARM Agency Securities.

Capstead reported net income of $38 million or $0.37 per diluted common share for the first quarter of 2014 compared to $37 million or $0.35 per diluted common share for the fourth quarter of 2013 and $35 million or $0.31 per diluted common share for the first quarter of 2013.

Financing spreads on residential mortgage investments averaged 1.30% for the first quarter of 2014, compared to 1.25% for the fourth quarter of 2013 and 1.15% for the first quarter of 2013. Financing spreads on residential mortgage investments is a non-GAAP financial measure based solely on yields on residential mortgage investments, net of borrowing rates on repurchase arrangements and similar borrowings, adjusted for currently-paying interest rate swap agreements held for hedging purposes. This measure differs from total financing spreads, an all-inclusive GAAP measure that includes yields on all interest-earning assets, as well as rates paid on all interest-bearing liabilities, principally unsecured borrowings. See page 28 for a reconciliation of these GAAP and non-GAAP financial measures. Higher financing spreads reflect lower investment premium amortization as a result of lower mortgage prepayment rates offset by the effects of a lower average portfolio outstanding and lower cash yields on the portfolio because of the effects of ARM loan coupon interest rates resetting lower to more current rates as well as lower coupon interest rates on acquisitions. Average borrowing rates were unchanged from the fourth quarter of 2013 while considerably lower than in the first quarter of 2013.

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Index
Operating costs (salaries and benefits, incentive compensation and other general and administrative expense) as a percentage of long-term investment capital averaged 0.96% for the first quarter of 2014, compared to 1.07% for the fourth quarter of 2013 and 0.77% during the first quarter of 2013.

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 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.

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 are therefore included in the calculation of book value per common share (total stockholders' equity, less aggregate liquidation preferences for preferred shares, 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, among other factors. The Company's investment strategy attempts to mitigate these risks by focusing on investments in 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 the Company's book value per common share for the quarter ended March 31, 2014:

   Book value per common share, beginning of
   quarter                                                     $   12.47
   Earnings in excess of dividend                                                  0.3 %
   distributions                                                    0.03
   Change in unrealized gains and losses on
   mortgage securities classified as
   available-for-sale                            $    0.17
   Change in unrealized gains and losses on
   interest rate swap agreements designated as
   cash flow hedges of:
   Borrowings under repurchase arrangements          (0.01 )
   Unsecured borrowings                              (0.07 )
                                                                    0.09           0.7 %
   Book value per common share, end of quarter                 $   12.59

   Increase in book value per common share                     $    0.12           1.0 %
   during the quarter

Issuance of 7.50% Series E Perpetual Preferred Shares

In May 2013 Capstead completed a public offering of 6.8 million shares ($170 million face amount) of its 7.50% Series E Cumulative Redeemable Preferred Stock, liquidation preference $25.00 per share, using the $164 million in proceeds, net of underwriter fees and other costs, together with $43 million of cash on hand to fund the June 2013 redemption of the Company's Series A and B perpetual preferred shares. The Series E preferred shares are redeemable at the Company's option for $25.00 per share, plus any accumulated and unpaid dividends, on or after May 13, 2018.

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In late 2013 the Company began issuing additional Series E preferred shares through an at-the-market continuous offering program. During the quarter ended March 31, 2014, the Company issued 56,000 Series E preferred shares at an average price of $23.83, net of expenses, and has continued issuing Series E preferred shares subsequent to quarter-end. Modest additional amounts of Series E preferred capital may be raised in the future under this program subject to market conditions, compliance with federal securities laws and blackout periods associated with the dissemination of earnings and dividend announcements and other important Company-specific news.

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 Ginnie Mae, which is an agency of the federal government. Federal government support for the GSEs has largely alleviated market concerns regarding the ability of the GSEs to fulfill their guarantee obligations. By focusing on investing in seasoned, 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 ARM or fixed-rate assets. These declines are generally recoverable 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. This investment strategy positions the Company to benefit from potential recoveries in financing spreads that typically contract during periods of rising interest rates. The following table illustrates the progression of the Company's portfolio of residential mortgage investments for the quarter ended March 31, 2014 (dollars in thousands):

      Residential mortgage investments, beginning of quarter   $ 13,475,874
      Increase in net unrealized gains on securities
      classified as available-for-sale                               16,693
      Portfolio acquisitions (principal amount) at average
      lifetime purchased yields of 2.45%                            644,356
      Investment premiums on acquisitions*                           24,647
      Portfolio runoff (principal amount)                          (610,071 )
      Investment premium amortization                               (22,288 )
      Residential mortgage investments, end of quarter         $ 13,529,211

      Average residential mortgage investments outstanding
      during the quarter ended March 31, 2014                  $ 13,493,742

* Residential mortgage investments typically are acquired at a premium to the securities' unpaid principal balances. Investment premiums are recognized in earnings as portfolio yield adjustments using the interest method over the estimated lives of the related investments. As such, the level of mortgage prepayments impacts how quickly investment premiums are amortized.

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 the Company's 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.

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Index
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). After consideration of any applicable initial fixed-rate periods, at March 31, 2014 approximately 84%, 10% and 6% of the Company's ARM securities were backed by mortgage loans that reset annually, semi-annually and monthly, respectively. Approximately 84% 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 initial coupon reset date. Additionally, at March 31, 2014 approximately 15% 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 date. The Company's ARM holdings featured the following characteristics at March 31, 2014 (dollars in thousands):

                                                        Fully           Average         Average        Average         Months
                     Amortized            Net          Indexed            Net           Periodic       Lifetime          To
 ARM Type (a)      Cost Basis (b)       WAC (c)        WAC (c)        Margins (c)       Caps (c)       Caps (c)       Roll (a)
Current-reset
ARMs:
Fannie Mae        $      4,657,092           2.33 %         2.14 %            1.70 %         3.32 %        10.04 %          5.3
Agency
Securities
Freddie Mac              1,657,935           2.42           2.23              1.82           2.21          10.48            6.1
Agency
Securities
Ginnie Mae               1,229,990           2.50           1.65              1.51           1.04           8.76            8.0
Agency
Securities
Residential                  4,153           3.45           2.25              2.02           1.50          10.94            4.5
mortgage loans
                         7,549,170           2.38           2.08              1.70           2.71           9.93            5.9
Longer-to-reset
ARMs:
Fannie Mae               2,952,741           2.82           2.29              1.73           4.86           7.83           40.5
Agency
Securities
Freddie Mac              1,806,000           2.90           2.36              1.81           4.59           7.95           40.7
Agency
Securities
Ginnie Mae                 972,525           2.76           1.66              1.51           1.15           7.87           30.5
Agency
Securities
                         5,731,266           2.83           2.20              1.72           4.14           7.87           38.9
                  $     13,280,436           2.57           2.14              1.71           3.33           9.04           20.0

Gross WAC (rate                              3.18
paid by
borrowers) (d)

(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 March 31, 2014, the ratio of amortized cost basis to related unpaid principal balance for the Company's ARM securities was 103.27. This table excludes $2 million in fixed-rate Agency Securities, $2 million in fixed-rate residential mortgage loans and $2 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 underlying loans 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 have either 200 or 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 related current net WAC, for ARM securities subject only to lifetime caps. At quarter-end, 71% of current-reset ARMs were subject to periodic caps averaging 1.82%; 16% were subject to initial caps averaging 2.89%; 12% were subject to lifetime caps, less related current net WAC, averaging 7.66%; and 1% were not subject to a cap. All longer-to-reset ARM securities at March 31, 2014 were subject to initial caps.

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

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Index
Capstead generally pledges its residential mortgage investments as collateral under repurchase arrangements with commercial banks and other financial institutions, referred to as counterparties, the terms and conditions of which are negotiated on a transaction-by-transaction basis 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." Haircuts on outstanding borrowings averaged 4.6 percent and ranged from 3.0 to 5.0 percent of the fair value of pledged residential mortgage pass-through securities at March 31, 2014, little changed from the prior year. After considering haircuts and related interest receivable on the collateral, as well as interest payable on these borrowings, the Company had $656 million of capital at risk with its lending counterparties as of March 31, 2014.

Interest rates charged on repurchase arrangements, referred to as repo borrowing rates, 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 fund 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 arrangements and similar borrowings at March 31, 2014 consisted of $12.59 billion of primarily 30-day borrowings with 22 counterparties at average rates of 0.32%, before the effects of interest rate swap agreements held as cash flow hedges and 0.48% including the effects of these derivatives.

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 offset a significant portion of the interest accruing on a like amount of the Company's 30- to 90-day borrowings. As a result, the Company's effective borrowing rate for these borrowings consists of fixed-rate payments made on the swap agreements adjusted for differences between variable rate payments received on the swap agreements and related actual repo borrowing rates, as well as the effects of measured hedge ineffectiveness.

At March 31, 2014, the Company held portfolio financing-related swap agreements totaling $7.20 billion notional amount with average contract expirations of 17 months. These swap positions consisted of (a) $5.70 billion notional amount in currently-paying swap agreements requiring the payment of fixed rates of interest averaging 0.50% for average remaining interest-payment terms of 15 months and (b) $1.50 billion notional amount in forward-starting swap agreements that will begin requiring fixed rate interest payments averaging 0.49% for two-year periods that commence on various dates between April 2014 and July 2014, with average contract expirations of 25 months. During the quarter ended March 31, 2014 Capstead entered into new forward-starting swap agreements with notional amounts totaling $700 million requiring fixed rate interest payments averaging 0.52% for two-year periods that commence on various dates between April 2014 and July 2014. Also during the current quarter, $200 million notional amount of swaps requiring fixed rate interest payments averaging 0.60% matured, while $1.70 billion notional amount of previously acquired forward-starting swaps requiring fixed rate interest payments averaging 0.51% moved into current-pay status. After consideration of all portfolio financing-related swap positions entered into as of quarter-end, the Company's residential mortgage investments and related borrowings had estimated durations at March 31, 2014 of 11 and 9 months, respectively, for a net duration gap of approximately two months - see pages 33 and 34 under the caption "Interest Rate Risk" for further information about the Company's sensitivity to changes in market interest rates. 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 interest rate swap agreements as well as longer-dated repurchase arrangements if available at attractive terms.

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Index
Components of quarterly financing spreads on residential mortgage investments, a non-GAAP financial measure, and mortgage prepayment rates, expressed as an annualized constant prepayment rate, or "CPR," were as follows for the indicated periods:

                    2014                          2013                                      2012
                     Q1          Q4          Q3          Q2          Q1          Q4          Q3          Q2
Yields on
residential
mortgage
investments:(a)
Cash yields           2.46 %      2.48 %      2.50 %      2.52 %      2.57 %      2.60 %      2.65 %      2.71 %
Investment
premium              (0.67 )     (0.74 )     (1.14 )     (0.99 )     (0.84 )     (0.84 )     (0.79 )     (0.67 )
amortization
Adjusted yields       1.79        1.74        1.36        1.53        1.73        1.76        1.86        2.04
Related
borrowing
rates:(b)
Repo borrowing        0.34        0.38        0.37        0.39        0.41        0.45        0.41        0.37
rates
Fixed swap rates      0.50        0.52        0.59        0.65        0.71        0.75        0.78        0.80
Adjusted              0.49        0.49        0.49        0.53        0.58        0.63        0.56        0.54
borrowing rates
Financing
spreads on
residential           1.30        1.25        0.87        1.00        1.15        1.13        1.30        1.50
mortgage
investments
CPR                  15.16       17.14       25.49       23.12       20.05       19.99       19.14       16.31

(a) Cash yields are based on the cash component of interest income. Investment premium amortization is determined using the interest method which incorporates actual and anticipated future mortgage prepayments. Both are expressed as a percentage calculated on an annualized basis on average amortized cost basis for the indicated periods.

(b) Repo borrowing rates represent average rates on repurchase agreements and similar borrowings, before consideration of related currently-paying interest rate swap agreements.

Fixed swap rates represent the average fixed-rate payments made on currently-paying interest rate swap agreements held for portfolio hedging purposes and exclude differences between LIBOR-based variable-rate payments received on these swaps and repo borrowing rates, as well as the effects of any hedge ineffectiveness. These differences averaged 18 basis points on average currently-paying swap notional amounts outstanding during the first quarter of 2014.

Adjusted borrowing rates reflect repo borrowing rates, fixed swap rates and the above-mentioned differences. All rates presented are expressed as a percentage calculated on an annualized basis for the indicated periods.

First quarter 2014 cash yields declined by two basis points from fourth quarter 2013 cash yields reflecting lower coupon interest rates on mortgage loans underlying the Company's holdings of ARM securities resulting from changes in portfolio composition due to acquisitions and portfolio runoff as well as ARM loan coupon resets. Declines in coupon interest rates because of ARM coupon resets have moderated as an increasing number of these loans approach fully-indexed levels.

Investment premium amortization is primarily driven by changes in mortgage prepayment rates and investment premium levels. As older, lower-basis securities held by the Company prepay, the cost basis of the portfolio . . .

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