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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED: JUNE 30, 2002
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: 1-8996
CAPSTEAD MORTGAGE CORPORATION
(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 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 X NO
--- ---
APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the last practicable date.
Common Stock ($0.01 par value) 13,897,508 as of August 12, 2002
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CAPSTEAD MORTGAGE CORPORATION
FORM 10-Q
FOR THE QUARTER ENDED JUNE 30, 2002
INDEX
PART I. -- FINANCIAL INFORMATION
PAGE
----
ITEM 1. Financial Statements
Consolidated Balance Sheets -- June 30, 2002 and December 31, 2001..................................... 3
Consolidated Statements of Operations -- Quarter and Six Months Ended
June 30, 2002 and 2001............................................................................... 4
Consolidated Statements of Cash Flows -- Six Months Ended June 30, 2002 and 2001....................... 5
Notes to Consolidated Financial Statements............................................................. 6
ITEM 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations............................................. 17
ITEM 3. Qualitative and Quantitative Disclosure of Market Risk...................................... 31
PART II. -- OTHER INFORMATION
ITEM 6. Exhibits and Reports on Form 8-K............................................................ 31
SIGNATURES................................................................................................ 31
-2-
ITEM 1. FINANCIAL STATEMENTS
PART I. -- FINANCIAL INFORMATION
CAPSTEAD MORTGAGE CORPORATION
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
JUNE 30, 2002 DECEMBER 31, 2001
------------- -----------------
(UNAUDITED)
ASSETS
Mortgage securities and similar investments
($2.7 billion pledged under repurchase arrangements) $ 2,905,108 $ 3,455,219
CMO collateral and investments 1,678,612 2,262,305
------------- -----------------
4,583,720 5,717,524
Real estate held for lease, net of accumulated depreciation 143,515 --
Prepaids, receivables and other 39,363 54,381
Cash and cash equivalents 103,937 123,520
------------- -----------------
$ 4,870,535 $ 5,895,425
============= =================
LIABILITIES
Repurchase arrangements and similar borrowings $ 2,653,031 $ 3,207,068
Collateralized mortgage obligations ("CMOs") 1,665,577 2,245,015
Borrowings secured by real estate 120,648 --
Incentive fee payable to management and affiliate 3,224 9,422
Accounts payable and accrued expenses 7,597 29,192
------------- -----------------
4,450,077 5,490,697
------------- -----------------
STOCKHOLDERS' EQUITY
Preferred stock - $0.10 par value; 100,000 shares authorized:
$1.60 Cumulative Preferred Stock, Series A,
273 and 273 shares issued and outstanding at
June 30, 2002 and December 31, 2001, respectively
($4,472 aggregate liquidation preference) 3,814 3,821
$1.26 Cumulative Convertible Preferred Stock, Series B,
15,842 and 15,842 shares issued and outstanding at
June 30, 2002 and December 31, 2001, respectively
($180,283 aggregate liquidation preference) 176,961 176,961
Common stock - $0.01 par value; 100,000 shares authorized;
13,898 and 13,862 shares issued and outstanding at
June 30, 2002 and December 31, 2001, respectively 139 139
Paid-in capital 559,839 559,571
Accumulated deficit (367,932) (387,718)
Accumulated other comprehensive income 47,637 51,954
------------- -----------------
420,458 404,728
------------- -----------------
$ 4,870,535 $ 5,895,425
============= =================
See accompanying notes to consolidated financial statements.
-3-
CAPSTEAD MORTGAGE CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
QUARTER ENDED SIX MONTHS ENDED
JUNE 30 JUNE 30
-------------------------- --------------------------
2002 2001 2002 2001
---------- ---------- ---------- ----------
INTEREST INCOME:
Mortgage securities and similar investments $ 40,067 $ 74,055 $ 85,835 $ 161,597
CMO collateral and investments 30,696 52,410 68,130 108,195
---------- ---------- ---------- ----------
Total interest income 70,763 126,465 153,965 269,792
---------- ---------- ---------- ----------
INTEREST AND RELATED EXPENSE:
Repurchase arrangements and similar borrowings 12,965 45,670 27,011 110,831
CMO borrowings 30,979 52,358 68,965 107,973
Mortgage insurance and other 155 259 324 588
---------- ---------- ---------- ----------
Total interest and related expense 44,099 98,287 96,300 219,392
---------- ---------- ---------- ----------
Net margin on financial assets 26,664 28,178 57,665 50,400
---------- ---------- ---------- ----------
REAL ESTATE LEASE INCOME 2,187 -- 2,187 --
---------- ---------- ---------- ----------
REAL ESTATE-RELATED EXPENSE:
Interest 1,296 -- 1,296 --
Depreciation 642 -- 642 --
---------- ---------- ---------- ----------
Total real estate-related expense 1,938 -- 1,938 --
---------- ---------- ---------- ----------
Net margin on real estate held for lease 249 -- 249 --
---------- ---------- ---------- ----------
OTHER REVENUE (EXPENSE):
Gain on asset sales -- 986 -- 6,849
CMO administration and other 753 1,612 1,200 2,331
Management and affiliate incentive fee (1,630) (1,630) (3,224) (4,371)
Other operating expense (1,450) (1,377) (2,929) (2,792)
---------- ---------- ---------- ----------
Total other revenue (expense) (2,327) (409) (4,953) 2,017
---------- ---------- ---------- ----------
NET INCOME $ 24,586 $ 27,769 $ 52,961 $ 52,417
========== ========== ========== ==========
Net income $ 24,586 $ 27,769 $ 52,961 $ 52,417
Less cash dividends paid on preferred stock (5,099) (4,387) (10,199) (10,280)
---------- ---------- ---------- ----------
Net income available to common stockholders $ 19,487 $ 23,382 $ 42,762 $ 42,137
========== ========== ========== ==========
NET INCOME PER COMMON SHARE:
Basic $ 1.41 $ 1.77 $ 3.09 $ 3.27
Diluted 1.24 1.63 2.67 3.01
CASH DIVIDENDS DECLARED PER SHARE:
Common $ 1.430 $ 1.560 $ 3.080 $ 2.540
Series A Preferred 0.400 0.400 0.800 0.800
Series B Preferred 0.315 0.315 0.630 0.630
See accompanying notes to consolidated financial statements.
-4-
CAPSTEAD MORTGAGE CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)
SIX MONTHS ENDED
JUNE 30
------------------------------
2002 2001
------------ ------------
OPERATING ACTIVITIES:
Net income $ 52,961 $ 52,417
Noncash items:
Amortization of discount and premium 11,614 16,296
Depreciation and other amortization 1,447 553
Gain on asset sales -- (6,849)
Net change in prepaids, receivables, other assets,
accounts payable and accrued expenses (14,200) (14,208)
------------ ------------
Net cash provided by operating activities 51,822 48,209
------------ ------------
INVESTING ACTIVITIES:
Purchases of mortgage securities and similar investments (89,226) (110,480)
Purchase of real estate (23,320) --
Principal collections on mortgage securities
and similar investments 629,424 876,805
Proceeds from asset sales -- 540,862
CMO collateral:
Principal collections 578,226 293,134
Decrease in accrued interest receivable 3,517 2,228
Increase in short-term investments (2) (337)
------------ ------------
Net cash provided by investing activities 1,098,619 1,602,212
------------ ------------
FINANCING ACTIVITIES:
Decrease in repurchase arrangements and similar borrowings (554,037) (965,908)
Decrease in borrowings secured by real estate (189) --
CMO borrowings:
Principal payments on securities (579,620) (356,325)
Decrease in accrued interest payable (3,239) (2,443)
Capital stock transactions 191 (207,945)
Dividends paid (33,130) (23,742)
------------ ------------
Net cash used in financing activities (1,170,024) (1,556,363)
------------ ------------
Net change in cash and cash equivalents (19,583) 94,058
Cash and cash equivalents at beginning of period 123,520 21,761
------------ ------------
Cash and cash equivalents at end of period $ 103,937 $ 115,819
============ ============
See accompanying notes to consolidated financial statements.
-5-
CAPSTEAD MORTGAGE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2002
(UNAUDITED)
NOTE 1 -- BUSINESS
Capstead Mortgage Corporation operates as a real estate investment trust
("REIT") earning income from investing in real estate-related assets on a
leveraged basis and from other investment strategies. These investments
currently include, but are not limited to, adjustable-rate single-family
residential mortgage-backed securities issued by government-sponsored entities,
either Fannie Mae, Freddie Mac or Ginnie Mae ("Agency Securities"). Capstead has
also made limited investments in credit-sensitive commercial real estate-related
assets, including the direct ownership of real estate (see NOTE 7), intended to
produce attractive returns due largely to a higher risk of default and reduced
liquidity compared to Agency Securities. The Company continues to evaluate
suitable real estate-related investments, which may include more
credit-sensitive assets. Management believes that such investments, when
combined with the prudent use of leverage, can provide attractive returns over
the long term with less sensitivity to changes in interest rates.
Capstead's investment portfolios declined during 2001 and thus far in 2002
primarily because of high levels of mortgage prepayments. To the extent proceeds
of runoff or asset sales are not reinvested, or cannot be reinvested, at a rate
of return at least equal to the rate previously earned on that capital, earnings
may decline. 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 attractive
pricing.
NOTE 2 -- BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements have been prepared
in accordance with generally accepted accounting principles 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 generally accepted accounting principles 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 quarter ended June 30, 2002 are not
necessarily indicative of the results that may be expected for the calendar year
ending December 31, 2002. For further information refer to the consolidated
financial statements and footnotes thereto included in the Company's annual
report on Form 10-K for the year ended December 31, 2001.
Relative to directly owning real estate for the first time (see NOTE 7), the
Company has adopted the following accounting policies:
Real Estate Useful Lives -- Land, buildings, equipment and fixtures are carried
at cost less accumulated depreciation. Depreciation is provided using the
straight-line method over the useful lives of the buildings, equipment and
fixtures, as follows:
Buildings 40 years
Equipment and fixtures 5 years
Impairment of Real Estate Values -- Should a significant adverse event or change
in circumstances occur, management will assess if the values of the Company's
real estate properties have become impaired. A property is considered impaired
only if estimated operating cash flows (undiscounted and without interest
-6-
charges) of a property over its remaining useful life is less than its net
carrying value. If impaired, the difference between a property's net carrying
value and its fair value would be included in Other revenue (expense) as an
impairment charge.
Revenue Recognition -- Base rents are recognized on a straight-line basis over
the term of the related leases. Base rent escalations, when present, are
recognized when earned if dependent upon unknown factors such as increases in
the CPI.
NOTE 3 -- SECOND QUARTER COMMON DIVIDEND
On July 18, 2002 the Board of Directors declared a second quarter dividend of
$1.43 per common share, payable August 20, 2002 to stockholders of record as of
August 9, 2002.
NOTE 4 -- NET INCOME PER COMMON SHARE
Basic 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, by the weighted average number of common shares
and common share equivalents outstanding, giving effect to dilutive stock
options and dilutive convertible preferred shares. The components of the
computation of basic and diluted net income per share were as follows (in
thousands, except per share data):
QUARTER ENDED JUNE 30 SIX MONTHS ENDED JUNE 30
-------------------------- --------------------------
2002 2001 2002 2001
---------- ---------- ---------- ----------
NUMERATOR FOR BASIC NET INCOME PER COMMON SHARE:
Net income $ 24,586 $ 27,769 $ 52,961 $ 52,417
Less all preferred share dividends (5,099) (4,387) (10,199) (10,280)
---------- ---------- ---------- ----------
Net income available to common stockholders $ 19,487 $ 23,382 $ 42,762 $ 42,137
========== ========== ========== ==========
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING 13,856 13,213 13,840 12,887
BASIC NET INCOME PER COMMON SHARE $ 1.41 $ 1.77 $ 3.09 $ 3.27
NUMERATOR FOR DILUTED NET INCOME PER COMMON SHARE:
Net income $ 24,586 $ 27,769 $ 52,961 $ 52,417
Less cash dividends paid on antidilutive
convertible preferred shares (Series B shares) -- (4,990) -- (9,981)
---------- ---------- ---------- ----------
$ 24,586 $ 22,779 $ 52,961 $ 42,436
========== ========== ========== ==========
DENOMINATOR FOR DILUTED NET INCOME PER COMMON SHARE:
Weighted average common shares outstanding 13,856 13,213 13,840 12,887
Net effect of dilutive stock options 56 75 65 79
Net effect of dilutive preferred shares 5,901 689 5,901 1,118
---------- ---------- ---------- ----------
19,813 13,977 19,806 14,084
========== ========== ========== ==========
DILUTED NET INCOME PER COMMON SHARE $ 1.24 $ 1.63 $ 2.67 $ 3.01
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 Series A preferred shares were dilutive during the periods
presented. The Series B preferred shares became dilutive after a new conversion
rate went into effect July 2, 2001, even though few actual Series B conversions
subsequently occurred because it was uneconomical to convert at the market
prices of both the common shares and Series B preferred shares in effect during
the ensuing periods.
-7-
NOTE 5 -- MORTGAGE SECURITIES AND SIMILAR INVESTMENTS
Mortgage securities and similar investments and the related average effective
interest rates were as follows (dollars in thousands):
AVERAGE
PRINCIPAL PREMIUMS CARRYING AVERAGE EFFECTIVE
BALANCE (DISCOUNT) BASIS AMOUNT COUPON RATE
------------ ------------ ------------ ------------ ---------- ----------
(a) (b) (b)
JUNE 30, 2002
Agency Securities:
FNMA/FHLMC:
Fixed-rate $ 4,327 $ 25 $ 4,352 $ 4,530 10.00% 9.40%
Medium-term 19,875 (253) 19,622 20,495 6.03 6.04
LIBOR/CMT ARMs 1,290,736 20,225 1,310,961 1,335,024 5.96 5.23
COFI ARMs 142,715 (4,133) 138,582 144,142 4.19 5.18
GNMA ARMs 1,088,170 11,887 1,100,057 1,113,733 6.03 5.41
------------ ------------ ------------ ------------
2,545,823 27,751 2,573,574 2,617,924 5.90 5.32
Non-agency securities(c) 84,818 838 85,656 86,824 5.81 5.68
CMBS(c) 160,548 (551) 159,997 160,422 3.76 4.14
Commercial loans(c) 39,900 38 39,938 39,938 8.50 8.46
------------ ------------ ------------ ------------
$ 2,831,089 $ 28,076 $ 2,859,165 $ 2,905,108 5.81 5.31
============ ============ ============ ============
DECEMBER 31, 2001
Agency Securities:
FNMA/FHLMC:
Fixed-rate $ 5,706 $ 34 $ 5,740 $ 5,981 10.00% 9.29%
Medium-term 40,559 (149) 40,410 41,544 6.19 6.44
LIBOR/CMT ARMs 1,543,867 25,286 1,569,153 1,593,115 6.88 6.59
COFI ARMs 167,080 (4,839) 162,241 168,856 5.31 6.45
GNMA ARMs 1,368,551 14,460 1,383,011 1,398,908 6.37 6.40
------------ ------------ ------------ ------------
3,125,763 34,792 3,160,555 3,208,404 6.57 6.49
Non-agency securities(c) 73,040 373 73,413 74,839 6.94 7.58
CMBS(c) 172,071 (380) 171,691 171,976 3.69 6.46
------------ ------------ ------------ ------------
$ 3,370,874 $ 34,785 $ 3,405,659 $ 3,455,219 6.43 6.52
============ ============ ============ ============
(a) Includes mark-to-market for securities classified as
available-for-sale, if applicable (see NOTE 9).
(b) Average Coupon is presented as of the indicated balance sheet date.
Average Effective Rate is presented for the quarter then ended,
calculated including 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.
The Company classifies its Agency Securities and non-agency securities by
interest rate characteristics of the underlying single-family residential
mortgage loans. Commercial mortgage-backed securities ("CMBS") and commercial
loans are classified in a similar fashion. Fixed-rate mortgage securities have
fixed rates of interest for their entire terms. Medium-term mortgage securities
either (i) have an initial fixed-rate period of 3 or 5 years after origination
and then adjust annually based on a specified margin over the 1-year Constant
Maturity U.S. Treasury Note Rate ("1-year CMT"), (ii) have initial interest
rates that adjust one time, approximately 3 or 5 years after origination, based
on a specified margin over Fannie Mae yields for 30-year, fixed-rate commitments
at the time of adjustment, or (iii) are fixed-rate mortgage securities that have
initial expected weighted average lives of 5 years or less. Adjustable-rate
mortgage ("ARM") securities either (i) adjust annually based on a specified
margin over 1-year CMT, (ii) adjust semiannually based on a specified margin
over the 6-month London Interbank Offered Rate ("LIBOR"),
-8-
(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"), or (iv) were previously classified as medium-term and have begun
adjusting annually based on a specified margin over 1-year CMT. CMBS and
commercial loans held as of June 30, 2002 adjust monthly based on a specified
margin over 30-day LIBOR.
Agency Securities are AAA-rated and are considered to have limited credit risk.
Non-agency securities consist of private mortgage pass-through securities backed
primarily by single-family non-conforming residential mortgage loans whereby the
related credit risk of the underlying loans is borne by AAA-rated private
mortgage insurers ("Non-agency Securities"). 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. CMBS held
by the Company at June 30, 2002 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 loans held by
the Company as of June 30, 2002 consist of a loan to a joint venture that holds
commercial real estate. The maturity of mortgage-backed securities is directly
affected by the rate of principal prepayments on the underlying loans.
NOTE 6 -- CMO COLLATERAL AND INVESTMENTS
CMO collateral consists of primarily fixed-rate mortgage securities
collateralized by single-family residential mortgage loans and related
short-term investments, both pledged to secure CMO borrowings ("Pledged CMO
Collateral"). All principal and interest on pledged mortgage securities is
remitted directly to collection accounts maintained by a trustee. The trustee is
responsible for reinvesting those funds in short-term investments. All
collections on the pledged mortgage securities and the reinvestment income
earned thereon are available for the payment of principal and interest on CMO
borrowings. The components of CMO collateral and investments were as follows (in
thousands):
JUNE 30, 2002 DECEMBER 31, 2001
------------- -----------------
Pledged CMO Collateral:
Pledged mortgage securities $ 1,652,559 $ 2,231,324
Short-term investments 31 30
Accrued interest receivable 9,812 13,329
------------- -----------------
1,662,402 2,244,683
Unamortized premium 13,397 14,860
------------- -----------------
1,675,799 2,259,543
CMO investments 2,813 2,762
------------- -----------------
$ 1,678,612 $ 2,262,305
============= =================
Pledged mortgage securities are primarily private mortgage pass-through
securities whereby the related credit risk of the underlying loans is borne by
AAA-rated private mortgage insurers or subordinated bonds within the related CMO
series to which the collateral is pledged. The Company has retained $190,000 of
credit risk held in the form of subordinated bonds associated with $184 million
of Pledged CMO Collateral outstanding at June 30, 2002. CMO investments
currently consist of reserve funds retained by the Company in connection with
two 1993 mortgage loan sales. These reserve funds are available to pay special
hazard (e.g. earthquake or mudslide-related losses) or certain bankruptcy costs
associated with $69 million of loans outstanding as of June 30, 2002 from the
related securitizations. The weighted average effective interest rate for total
Pledged CMO Collateral was 6.91% during the quarter ended June 30, 2002.
-9-
NOTE 7 -- REAL ESTATE HELD FOR LEASE
On May 1, 2002 Capstead acquired six independent senior living facilities
wherein the operator of the facility provides the tenants little, if any,
medical care and one skilled nursing facility (the "Properties"). The aggregate
purchase price of the Properties was $144.1 million including approximately $3.4
million in closing costs and the assumption by Capstead of $120.8 million of
related mortgage and tax-exempt bond debt resulting in an initial equity
investment of $23.3 million. The Properties were acquired pursuant to purchase
agreements initially negotiated and executed by subsidiaries of Brookdale Living
Communities, Inc. (collectively with its subsidiaries, "Brookdale") with an
affiliate of Apartment Investment Management Company ("AIMCO") and subsequently
assigned to Capstead. The Company has entered into a long-term 'net-lease'
arrangement with 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 (together with its affiliates, "Fortress").
Fortress is Capstead's largest stockholder and Wesley R. Edens, Capstead's
Chairman of the Board and Chief Executive Officer, also serves as Fortress'
chairman and chief executive.
The lease agreements negotiated with Brookdale consist of a master lease
covering all of the Properties and individual property-level leases (referred to
collectively as the "Lease"). The Lease has an initial term of 20 years and
provides for two 10-year renewal periods. Beginning at the end of five years,
Brookdale will have the option of purchasing all of the Properties from Capstead
at the greater of fair value or Capstead's original cost, after certain
adjustments. Under the terms of the Lease, 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, after an initial three-month rent concession period, an amount representing
an attractive cash return on Capstead's equity in the Properties after payment
of monthly debt service and subject to annual increases based upon increases
(capped at 3%) in the Consumer Price Index. The Lease qualifies as an operating
lease for financial reporting purposes with future minimum rentals expected to
exceed $10 million per year. The following table summarizes carrying amounts of
the Properties as of June 30, 2002 (in thousands):
Land $ 16,750
Buildings 123,607
Equipment and fixtures 3,800
---------
144,157
Accumulated depreciation (642)
---------
$ 143,515
=========
Concurrent with executing the purchase agreements for the Properties, Brookdale
also entered into an agreement with AIMCO to acquire from AIMCO $71.4 million
face amount of tax-exempt bonds secured by four of the Properties (the "Bonds")
for a purchase price of $60.7 million. With Capstead's May 1, 2002 acquisition
of the Properties and assumption of the Bonds and all other related debt,
Brookdale agreed to release AIMCO from its obligation to deliver the Bonds
pursuant to the bond purchase agreement in exchange for which AIMCO paid
Brookdale $4.6 million and Brookdale simultaneously entered into a two-year
total return swap agreement with respect to the Bonds with a notional swap
strike price of $65.4 million. Brookdale posted a $17 million bank letter of
credit for the benefit of the swap counterparty to secure its obligations
thereunder. The swap counterparty is a financial institution affiliated with a
tax-exempt bond fund that holds the Bonds. Upon termination of the swap,
Brookdale is obligated to pay the swap counterparty $65.4 million and will
receive an amount equal to the proceeds from either a sale or refinancing of the
bonds, as the case may be.
The Lease contemplates Capstead causing the refinancing of the Bonds through the
issuance of new credit-enhanced adjustable-rate tax-exempt bonds to unaffiliated
investors. Capstead has agreed to provide credit enhancement on up to $12.0
million of the new bonds by arranging for a letter of credit
-10-
from a rated lending institution. Brookdale will compensate Capstead for
arranging the letter of credit by paying additional base rent. The refinancing
is expected to enhance the value of the Properties by significantly lowering
interest costs and should be completed by year-end. In connection with its
assumption of the Bonds, Capstead deposited $8.4 million in mortgage securities
with the bond trustee (which securities will be returned to Capstead on the
refinancing date).
NOTE 8 -- REPURCHASE ARRANGEMENTS AND SIMILAR BORROWINGS
Repurchase 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):
JUNE 30, 2002 DECEMBER 31, 2001
------------------------- -------------------------
BORROWINGS AVERAGE BORROWINGS AVERAGE
OUTSTANDING RATE OUTSTANDING RATE
------------ -------- ------------ --------
Repurchase arrangements:
Agency Securities (less than 31 days) $ 2,438,735 1.81% $ 2,999,860 1.88%
Non-agency Securities
(less than 31 days) 43,784 1.90 55,602 2.05
CMBS (less than 1 year) 140,597 2.13 151,606 2.23
------------ ------------
2,623,116 1.83 3,207,068 1.90
Commercial bank borrowings 29,915 4.34 -- --
------------ ------------
$ 2,653,031 1.85 $ 3,207,068 1.90
============ ============
Borrowings made under uncommitted repurchase arrangements with investment
banking firms 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 June 30, 2002 consist of an adjustable-rate loan that matures in 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 repurchase arrangements and similar borrowings was 1.85% during the quarter
ended June 30, 2002.
NOTE 9 -- CMO BORROWINGS
Each series of CMOs issued consists of various classes of bonds, most of which
have fixed rates of interest. Interest is payable monthly or quarterly at
specified rates for all classes. Typically, principal payments on each series
are made to each class in the order of their stated maturities so that no
payment of principal will be made on any class of bonds until all classes having
an earlier stated maturity have been paid in full. The components of CMOs along
with selected other information were as follows (dollars in thousands):
JUNE 30, 2002 DECEMBER 31, 2001
----------------- -----------------
CMOs $ 1,649,828 $ 2,228,091
Accrued interest payable 9,014 12,253
----------------- -----------------
Total obligation 1,658,842 2,240,344
Unamortized premium 6,735 4,671
----------------- -----------------
$ 1,665,577 $ 2,245,015
================= =================
Range of average interest rates 2.20% to 9.95% 2.29% to 9.45%
Range of stated maturities 2008 to 2030 2008 to 2030
Number of series 18 19
-11-
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, generally at the Company's option, provided that certain
requirements specified in the related indenture have been met (referred to as
"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 was 7.01% during the quarter ended June 30, 2002.
NOTE 10 -- BORROWINGS SECURED BY REAL ESTATE
The components of borrowings secured by real estate and related weighted average
interest rates, were as follows (dollars in thousands):
JUNE 30, 2002
-------------------------
BORROWINGS AVERAGE
OUTSTANDING RATE
------------ --------
Mortgage borrowings $ 19,643 7.92%
Tax-exempt bonds 101,005 6.66
------------
$ 120,648 6.86
============
Mortgage borrowings consist of a fixed-rate mortgage secured by one senior
living facility that matures in 2009. The tax-exempt bonds are secured by
mortgages on five senior living facilities that mature in 2026. These bonds are
expected to be refinanced prior to year-end (see NOTE 7).
NOTE 11 -- DISCLOSURES REGARDING FAIR VALUES OF DEBT SECURITIES
Estimated fair values of debt securities have been 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, CMBS and CMO
investments 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 financial assets not held in the form of debt or
equity securities are excluded from these disclosures.
-12-
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 JUNE 30, 2002
Agency Securities:
Fixed-rate $ 1,916 $ 178 $ -- $ 2,094
Medium-term 19,622 873 -- 20,495
ARMs 2,549,600 43,345 46 2,592,899
---------- ---------- ---------- ----------
2,571,138 44,396 46 2,615,488
Non-agency Securities 85,125 1,170 2 86,293
CMBS 159,997 425 -- 160,422
CMO collateral and investments 33,128 973 37 34,064
---------- ---------- ---------- ----------
$2,849,388 $ 46,964 $ 85 $2,896,267
========== ========== ========== ==========
AS OF DECEMBER 31, 2001
Agency Securities:
Fixed-rate $ 2,596 $ 241 $ -- $ 2,837
Medium-term 40,410 1,134 -- 41,544
ARMs 3,114,405 46,680 206 3,160,879
---------- ---------- ---------- ----------
3,157,411 48,055 206 3,205,260
Non-agency Securities 72,458 1,426 -- 73,884
CMBS 171,691 285 -- 171,976
CMO collateral and investments 44,644 1,491 38 46,097
---------- ---------- ---------- ----------
$3,446,204 $ 51,257 $ 244 $3,497,217
========== ========== ========== ==========
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. 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 JUNE 30, 2002
Released CMO Collateral:
Agency Securities $ 2,436 $ 221 $ -- $ 2,657
Non-agency Securities 531 52 -- 583
Pledged CMO Collateral 1,644,548 953 7,241 1,638,260
---------- ---------- ---------- ----------
$1,647,515 $ 1,226 $ 7,241 $1,641,500
========== ========== ========== ==========
AS OF DECEMBER 31, 2001
Released CMO Collateral:
Agency Securities $ 3,144 $ 285 $ -- $ 3,429
Non-agency Securities 955 88 -- 1,043
Pledged CMO Collateral 2,216,208 1,455 10,084 2,207,579
---------- ---------- ---------- ----------
$2,220,307 $ 1,828 $ 10,084 $2,212,051
========== ========== ========== ==========
-13-
Sales of released CMO collateral classified as held-to-maturity occasionally
occur provided the collateral has paid down to within 15% of its original
issuance amounts. Dispositions of debt securities were as follows (in
thousands):
QUARTER ENDED JUNE 30 SIX MONTHS ENDED JUNE 30
------------------------- -------------------------
2002 2001 2002 2001
---------- ---------- ---------- ----------
Sale of securities held available-for-sale:
Amortized cost $ -- $ -- $ -- $ 451,319
Gain -- -- -- 5,863
Sale of released CMO collateral held-to-maturity:
Amortized cost -- 82,958 -- 82,958
Gain -- 986 -- 986
NOTE 12 -- COMPREHENSIVE INCOME
Comprehensive 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 2001 periods also
include the effect on other comprehensive income (loss) of adopting Statement of
Financial Accounting Standards No. 133 "Accounting for Derivative Instruments
and Hedging Activities" ("SFAS 133"). The following table provides information
regarding comprehensive income (in thousands):
QUARTER ENDED SIX MONTHS ENDED
JUNE 30 JUNE 30
---------------------- ----------------------
2002 2001 2002 2001
-------- -------- -------- --------
Net income $ 24,586 $ 27,769 $ 52,961 $ 52,417
Other comprehensive income (loss):
Unrealized gain on Derivatives held as cash flow hedges:
Initial gain upon adoption of SFAS 133 -- -- -- 1,365
Change in unrealized gain during period 46 54 (58) (318)
Reclassification adjustment for amounts
included in net income (95) (11) (125) (24)
-------- -------- -------- --------
(49) 43 (183) 1,023
Unrealized gain on debt securities:
Change in unrealized gain during period 935 4,832 (4,134) 30,584
Reclassification adjustment for gain
included in net income -- -- -- (5,863)
-------- -------- -------- --------
Other comprehensive income (loss) 886 4,875 (4,317) 25,744
-------- -------- -------- --------
Comprehensive income $ 25,472 $ 32,644 $ 48,644 $ 78,161
======== ======== ======== ========
-14-
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 JUNE 30
------------------------------------------------
2002 2001
--------------------- ---------------------
AMOUNT AVERAGE AMOUNT AVERAGE
-------- -------- -------- --------
Interest income:
Mortgage securities and similar investments $ 40,067 5.31% $ 74,055 6.68%
CMO collateral and investments 30,696 6.90 52,410 7.27
-------- --------
Total interest income 70,763 126,465
-------- --------
Interest expense:
Repurchase arrangements and similar
borrowings 12,965 1.85 45,670 4.43
CMO borrowings 30,979 7.01 52,358 7.31
-------- --------
Total interest expense 43,944 98,028
-------- --------
$ 26,819 $ 28,437
======== ========
SIX MONTHS ENDED JUNE 30
--------------------------------------------------
2002 2001
---------------------- ----------------------
AMOUNT AVERAGE AMOUNT AVERAGE
-------- --------- -------- ---------
Interest income:
Mortgage securities and similar investments $ 85,835 5.44% $161,597 6.89%
CMO collateral and investments 68,130 7.09 108,195 7.30
-------- --------
Total interest income 153,965 269,792
-------- --------
Interest expense:
Repurchase arrangements and similar
borrowings 27,011 1.85 110,831 5.15
CMOs borrowings 68,965 7.22 107,973 7.33
-------- --------
Total interest expense 95,976 218,804
-------- --------
$ 57,989 $ 50,988
======== ========
Changes in interest income and interest expense due to changes in interest rates
versus changes in volume were as follows (in thousands):
QUARTER ENDED JUNE 30, 2002
------------------------------------
RATE* VOLUME* TOTAL
-------- -------- --------
Interest income:
Mortgage securities and similar investments $(13,157) $(20,831) $(33,988)
CMO collateral and investments (2,516) (19,198) (21,714)
-------- -------- --------
Total interest income (15,673) (40,029) (55,702)
-------- --------
Interest expense:
Repurchase arrangements and similar
borrowings (21,097) (11,608) (32,705)
CMO borrowings (2,043) (19,336) (21,379)
-------- -------- --------
Total interest expense (23,140) (30,944) (54,084)
-------- -------- --------
$ 7,467 $ (9,085) $ (1,618)
======== ======== ========
-15-
SIX MONTHS ENDED JUNE 30, 2002
---------------------------------------
RATE* VOLUME* TOTAL
--------- --------- ---------
Interest income:
Mortgage securities and similar investments $ (29,451) $ (46,311) $ (75,762)
CMO collateral and investments (3,018) (37,047) (40,065)
--------- --------- ---------
Total interest income (32,469) (83,358) (115,827)
--------- --------- ---------
Interest expense:
Repurchase arrangements and similar
borrowings (55,920) (27,900) (83,820)
CMO borrowings (1,583) (37,425) (39,008)
--------- --------- ---------
Total interest expense (57,503) (65,325) (122,828)
--------- --------- ---------
$ 25,034 $ (18,033) $ 7,001
========= ========= =========
* 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 14 -- 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. In March 1999, these actions were consolidated
and in July 2000, 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. The amended complaint seeks monetary damages in an
undetermined amount. In February 2001, the Company responded to this amended
complaint with a motion to dismiss all allegations against the Company and the
named officers. In April 2001, the plaintiffs responded to the Company's motion
to dismiss and the Company filed its reply to the plaintiffs' response in May
2001. The Company believes it has meritorious defenses to the claims and intends
to vigorously defend the actions. Based on available information, management
believes the resolution of these suits will not have a material adverse effect
on the financial position of the Company.
NOTE 15 -- TRANSACTIONS WITH AFFILIATES
Fortress is Capstead's largest stockholder controlling over 26% of the Company's
outstanding common shares. Through a management contract, Fortress provides the
services of Mr. Edens as Capstead's chairman and chief executive and of other
individuals as necessary to perform support services for Mr. Edens. Under the
terms of this contract, Fortress is entitled to a $375,000 base annual fee and a
cash management incentive fee. Included in Other operating expense is $187,500
of base fees paid to Fortress for services rendered during the six months ended
June 30, 2002 and 2001, respectively. Fortress' incentive fees are included in
Management and affiliate incentive fee, which are based on the Company's
expected performance against predetermined benchmarks established by members of
the Board of Directors independent of Fortress.
-16-
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
FINANCIAL CONDITION
Capstead Mortgage Corporation ("Capstead" or the "Company") operates as a real
estate investment trust ("REIT") earning income from investing in real
estate-related assets on a leveraged basis and from other investment strategies.
These investments currently include, but are not limited to, adjustable-rate
single-family residential mortgage-backed securities issued by
government-sponsored entities, either Fannie Mae, Freddie Mac or Ginnie Mae
("Agency Securities"). The Company has also made limited investments in
credit-sensitive commercial real estate-related assets, including the direct
ownership of real estate, intended to produce attractive returns due largely to
a higher risk of default and reduced liquidity compared to Agency Securities. As
existing investments prepay or mature, Capstead has the opportunity to continue
to reinvest a portion of its equity capital into investments that can produce
attractive returns over the long term, with less sensitivity to changes in
interest rates than Agency Securities. To this end, the Company continues to
actively evaluate suitable real estate-related investments, which may include
more credit-sensitive assets. There can be no assurance that suitable
investments at attractive pricing will be available on a timely basis to replace
portfolio runoff as it occurs (see "Effects of Interest Rate Changes", "Risks
Associated with Credit-Sensitive Investments" and "Risks Associated with Owning
Real Estate").
MORTGAGE SECURITIES AND SIMILAR INVESTMENTS
As of June 30, 2002, mortgage securities and similar investments consisted
primarily of adjustable-rate mortgage ("ARM") Agency Securities (see "NOTE 5" to
the accompanying consolidated financial statements for discussion of how the
Company classifies its mortgage securities and other investments). 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 is borne by AAA-rated private
mortgage insurers. Commercial mortgage-backed securitizations ("CMBS") generally
have senior, mezzanine and subordinate classes of bonds with the lower classes
providing credit enhancement to the more senior classes. CMBS held by the
Company at June 30, 2002 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 loans held by
the Company at June 30, 2002 consist of a $39.9 million loan to a joint venture
that holds commercial real estate (see "Risks Associated With Credit-Sensitive
Investments").
Mortgage securities are financed under repurchase arrangements with investment
banking firms pursuant to which the portfolios are pledged as collateral.
Capstead financed its commercial loan investment with a $29.9 million loan from
a commercial bank. Should the Company acquire other investments that are not
mortgage-backed securities, similar financing arrangements with other parties,
such as commercial banks, may be employed (see "Liquidity and Capital
Resources").
The Company's portfolio of mortgage securities and similar investments declined
during the six months ended June 30, 2002 to $2.9 billion from $3.5 billion at
December 31, 2001, primarily as a result of portfolio runoff caused by mortgage
prepayments. Although still at elevated levels, mortgage prepayment rates
moderated during the first half of 2002 as interest rates on a substantial
portion of the mortgage loans underlying the Company's ARM securities reset to
levels at or below current interest rates on fixed-rate mortgage loans, reducing
or eliminating the advantage for these homeowners to refinance. Prepayments
should continue to moderate as the remaining loans reset to lower levels.
Acquisitions during 2002 have been limited to $29.4 million of ARM securities
released from CMO indentures, $59.8 million of adjustable-rate CMBS and
commercial loans, and $144.1 million of senior living properties (see "Real
Estate Held for Lease"). To the extent the proceeds of mortgage prepayments and
other maturities are not reinvested
-17-
or cannot be reinvested at a rate of return on invested capital at least equal
to the return earned on previous investments, earnings may decline. The future
size and composition of the Company's investment portfolios will depend on
market conditions, including levels of mortgage prepayments and the availability
of suitable investments at attractive pricing (see "Effects of Interest Rate
Changes").
The following yield and cost analysis illustrates results achieved during the
second quarter 2002 for components of the mortgage securities and similar
investments portfolio and anticipated third quarter 2002 asset yields and
borrowing rates as first projected by the Company on July 18, 2002 (the date
second quarter 2002 results were released and based on interest rates in effect
at that date) (dollars in thousands):
2ND QUARTER AVERAGE AS OF JUNE 30, 2002
------------------------------------- --------------------------- PROJECTED LIFETIME
ACTUAL ACTUAL PREMIUMS 3RD QUARTER PREPAYMENT
BASIS YIELD/COST RUNOFF (DISCOUNTS) BASIS YIELD/COST ASSUMPTIONS
---------- ---------- ------ ----------- ---------- ----------- -----------
(a) (a) (b) (b)
Agency securities:
FNMA/FHLMC:
Fixed-rate $ 4,634 9.40% 40% $ 25 $ 4,352 9.61% 25%
Medium-term 30,051 6.04 42 (253) 19,622 6.51 30
ARMs:
LIBOR/CMT 1,365,459 5.23 29 20,225 1,310,961 4.80 40
COFI 145,530 5.18 27 (4,133) 138,582 4.86 20
GNMA ARMs 1,172,699 5.41 37 11,887 1,100,057 5.06 26
---------- ----------- ----------
2,718,373 5.32 32 27,751 2,573,574 4.93 33
Non-agency securities 90,895 5.68 33 838 85,656 5.44 35
CMBS and other
commercial loans 199,552 5.00 44 (513) 199,935 5.25 --
---------- ----------- ----------
3,008,820 5.31 33 $ 28,076 2,859,165 4.97 31
===========
Borrowings 2,769,350 1.85 2,653,031 1.89
---------- ----------
Capital employed/
financing spread $ 239,470 3.46 $ 206,134 3.08
========== ==========
Return on assets(c) 3.59 3.24
(a) Basis represents 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 third quarter of 2002 reflect ARM
coupon resets and lifetime prepayment assumptions as adjusted for
expected prepayments for this quarter only, as of July 18, 2002. 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 is calculated on an annualized basis assuming the use of this
liquidity to reduce borrowing costs (see "Utilization of Capital and
Potential Liquidity").
The overall yield earned on this portfolio averaged 5.31% during the second
quarter of 2002, a decline of 55 basis points from an average yield of 5.86%
earned during the fourth quarter of 2001. 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 rates stabilize at rates in effect on July 18, 2002
(the date second quarter 2002 results were released), the average yield on the
portfolio could decline approximately 100 basis points by the second quarter of
2003. Actual yields will depend on portfolio composition as well as fluctuations
in, and market expectations for fluctuations in, interest rates and levels of
mortgage prepayments (see "Effects of Interest Rate Changes").
-18-
After having reduced the Federal Funds Rate by a total of 475 basis points
during 2001 to the lowest levels in four decades, the Federal Reserve changed
its bias on monetary policy to a neutral stance at its March 2002 meeting, an
indication that the U.S. economy is showing signs of strength and future
economic growth that may lead to higher short-term interest rates. The Company's
borrowing rates are currently expected to be little changed in the third quarter
from an average of 1.85% during the first half of 2002 but may increase by
year-end. The Company'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 market
liquidity (see "Effects of Interest Rate Changes").
CMO COLLATERAL AND INVESTMENTS
Since 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-family residential 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. The Company may or may not
retain a significant residual economic interest in these securitizations. 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 securitizations issued by the Company in 1993 and prior were treated as
sales transactions (referred to as "sold CMOs"). During the first half of 2002,
the Company did not issue any CMOs. From time to time, the Company exercises its
right to redeem previously issued CMOs (referred to as "clean-up calls") and
either sell or hold the released collateral for investment. Early in 2002, the
Company exercised clean-up calls related to two sold CMOs acquiring $29.4
million of ARM securities released from the related indentures.
Credit risk associated with pledged CMO collateral is borne by AAA-rated private
mortgage insurers or by subordinated bonds usually sold to investors. As of June
30, 2002, the Company had $190,000 of credit risk held in the form of
subordinated bonds retained by the Company associated with $184 million of
outstanding pledged CMO collateral. In connection with two 1993 sold CMOs,
Capstead retained $2.8 million of reserve funds that are available to pay
special hazard costs (e.g. earthquake or mudslide-related losses) or certain
bankruptcy costs associated with $69 million of loans outstanding as of June 30,
2002. Other than clean-up call rights, the Company does not hold any other
interests in sold CMOs.
CMO collateral and investments, net of related bonds, was $13.0 million at June
30, 2002, down from $17.3 million at December 31, 2001. Included in this net
investment are $6.7 million of the remaining CMO collateral premiums (net of CMO
bond premiums). Similar to premiums on other financial assets, CMO collateral
and bond premiums are amortized to income as CMO collateral yield or bond
expense adjustments based on both actual prepayments and lifetime prepayment
assumptions (see "Effects of Interest Rate Changes").
REAL ESTATE HELD FOR LEASE
On May 1, 2002 Capstead closed on its first direct investment in real estate, a
portfolio of seven senior living properties in five states (the "Properties").
Six of the seven Properties are primarily independent senior living facilities
wherein the operator of the facility provides the tenants little, if any,
medical care. The smallest property in the portfolio is primarily a skilled
nursing facility. This acquisition is in keeping with the Company's strategy of
making suitable real estate-related investments intended to produce attractive
returns over the long term, with less sensitivity to changes in interest rates
than most investments in residential mortgage-backed securities.
-19-
The following table summarizes the properties acquired:
YEAR
PROPERTY LOCATION UNITS OCCUPANCY OPENED
- --------------------------- ----------------- ------------------ ------------ ----------
(a) (b)
Chambrel at Roswell Roswell, GA 280 (256 IL; 24 AL) 90.7% 1987
Chambrel at Pinecastle Ocala, FL 161 (120 IL; 41 AL) 96.9 1986
Chambrel at Island Lake Longwood, FL 269 (229 IL; 40 AL) 96.3 1985
Chambrel at Montrose Akron, OH 168 (136 IL; 32 AL) 94.0 1987
Windsong at Chambrel Akron, OH 83 (75 SNF; 8 AL) 75.9 1997
Chambrel at Williamsburg Williamsburg, VA 256 (201 IL; 55 AL) 97.3 1987
Chambrel at Club Hill Garland, TX 260 (192 IL; 68 AL) 90.0 1987
Total 1,477 (1,134 IL; 268 AL; 75 SNF) 93.0
(a) IL refers to Independent Living units, AL refers to Assisted Living
units and SNF refers to Skilled Nursing Facility units.
(b) As of June 2002.
The aggregate purchase price of the Properties was $144.1 million including the
assumption by Capstead of $120.8 million of related mortgage and tax-exempt bond
debt resulting in an initial equity investment of $23.3 million. The Properties
were acquired from an affiliate of Apartment Investment and Management Company
("AIMCO") pursuant to a purchase contract negotiated by a subsidiary of
Brookdale Living Communities, Inc. (collectively with its subsidiaries,
"Brookdale"), and assigned to Capstead. Brookdale, an owner, operator, developer
and manager of senior living facilities, is a majority-owned affiliate of
Fortress Investment Group, LLC (together with its affiliates, "Fortress").
Fortress is Capstead's largest stockholder and Wesley R. Edens (Fortress'
Chairman of the Board and Chief Executive Officer) serves as Capstead's chairman
and chief executive.
The Company has entered into a long-term 'net-lease' arrangement with Brookdale
(the "Lease") under which Brookdale is responsible for the ongoing operation and
management of the Properties. The Lease has an initial term of 20 years and
provides for two 10-year renewal periods. Beginning at the end of five years,
Brookdale will have the option of purchasing all of the Properties from Capstead
at the greater of fair value or Capstead'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 on Capstead's equity in the
Properties after payment of monthly debt service. After an initial three-month
rent concession period, the cash return on Capstead's equity is expected to
exceed 15% on an annualized basis and is subject to annual increases based upon
increases (capped at 3%) in the Consumer Price Index. In keeping with Capstead's
strategy of reinvesting a portion of its capital into investments that can
produce attractive returns over the long term with less sensitivity to changes
in interest rates, any future changes in monthly debt service requirements are
the responsibility of Brookdale under the terms of the Lease (see "Risks
Associated with Owning Real Estate").
The Lease contemplates Capstead causing the refinancing of $71.4 million face
amount of tax-exempt bonds secured by four of the properties (the "Bonds")
through the issuance of new credit-enhanced adjustable-rate tax-exempt bonds.
Capstead has agreed to provide credit enhancement on up to $12.0 million of the
new bonds by arranging for a letter of credit from a rated lending institution.
Brookdale will compensate Capstead for arranging the letter of credit by paying
additional base rent. The refinancing is expected to enhance the value of the
Properties by significantly lowering interest costs and should be completed by
year-end. In connection with its assumption of the Bonds, Capstead deposited
$8.4 million in mortgage securities with the bond trustee (which securities will
be returned to Capstead on the refinancing date).
-20-
The Lease qualifies as an operating lease for financial reporting purposes. As
such, the Properties are carried as Real estate held for lease and the assumed
debt as Borrowings secured by real estate on the Company's balance sheet. The
majority of the purchase price is allocated to buildings, with land, equipment
and fixtures representing smaller components.
BOOK VALUE PER COMMON SHARE
At June 30, 2002 book value per common share was $14.25, compared to $14.59 at
December 31, 2001, (calculated excluding the $1.43 second quarter 2002 common
dividend declared July 18, 2002, and assuming redemption of the Series A and B
preferred shares). The decline in book value since year end reflects the impact
of the decline in size of the Company's investment portfolios that consist
primarily of mortgage-backed securities classified as held available-for-sale
and marked-to-market through stockholders' equity. The market value of these
investments can be expected to continue to decline with runoff and to fluctuate
with changes in interest rates and market liquidity, and such changes will be
reflected in book value per common share. Book value will also be affected by
other factors, including the level of dividend distributions; however, temporary
changes in market values of other real estate-related investments not held in
the form of debt or equity securities generally will not affect book value.
UTILIZATION OF CAPITAL AND POTENTIAL LIQUIDITY
The Company's utilization of capital and potential liquidity as of June 30, 2002
were as follows (in thousands):
CAPITAL POTENTIAL
ASSETS BORROWINGS EMPLOYED LIQUIDITY
---------- ---------- ---------- ----------
(a)
Mortgage securities and similar
investments:
Agency securities $2,617,924 $2,438,735 $ 179,189 $ 102,861
Non-agency securities 86,824 43,784 43,040 41,271
CMBS and other commercial
loans 200,360 170,512 29,848 1,900
---------- ---------- ---------- ----------
2,905,108 2,653,031 252,077 146,032
CMO collateral and investments 1,678,612 1,665,577 13,035 --
Real estate held for lease 143,515 120,648 22,867 --
---------- ---------- ---------- ----------
$4,727,235 $4,439,256 287,979 146,032
========== ==========
Other assets, net of other liabilities 132,479 103,937(b)
Second quarter common dividend(c) (19,873) (19,873)
---------- ----------
$ 400,585 $ 230,096
========== ==========
(a) Based on maximum borrowings available under existing uncommitted
repurchase arrangements considering the fair value of related
collateral as of June 30, 2002 (see "Liquidity and Capital Resources").
(b) Represents cash and cash equivalents.
(c) The second quarter common dividend was declared July 18, 2002 and is
payable August 20, 2002 to stockholders of record as of August 9, 2002.
The Company generally finances its mortgage securities and similar investments
with investment banking firms under repurchase arrangements (see "Liquidity and
Capital Resources"). CMO collateral and investments are generally 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 borrowing 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 the Company's investment
portfolios (see "Liquidity and Capital Resources" and "Effects of Interest Rate
Changes").
-21-
RESULTS OF OPERATIONS
Comparative net operating results (interest income or lease revenue, net of
related interest expense and, 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 SIX MONTHS ENDED
JUNE 30 JUNE 30
---------------------- ----------------------
2002 2001 2002 2001
-------- -------- -------- --------
Mortgage securities and similar investments:
Agency securities $ 24,523 $ 25,828 $ 53,880 $ 45,768
Non-agency securities 1,062 1,960 2,169 3,761
CMBS and other commercial loans 1,429 520 2,601 1,073
CMO collateral and investments (350) (130) (985) (202)
-------- -------- -------- --------
Net margin on financial assets 26,664 28,178 57,665 50,400
-------- -------- -------- --------
Real estate held for lease after related
interest expense 891 -- 891 --
Real estate depreciation (642) -- (642) --
-------- -------- -------- --------
Net margin on real estate held for lease 249 -- 249 --
-------- -------- -------- --------
Other revenue (expense):
Gain on asset sales -- 986 -- 6,849
CMO administration and other 753 1,612 1,200 2,331
Management and affiliate incentive fee (1,630) (1,630) (3,224) (4,371)
Other operating expense (1,450) (1,377) (2,929) (2,792)
-------- -------- -------- --------
Total other revenue (expense) (2,327) (409) (4,953) 2,017
-------- -------- -------- --------
Net income $ 24,586 $ 27,769 $ 52,961 $ 52,417
======== ======== ======== ========
Net income per common share:
Basic $ 1.41 $ 1.77 $ 3.09 $ 3.27
Diluted 1.24 1.63 2.67 3.01
Operating* 1.43 1.56 3.08 2.53
* Capstead reports operating income per common share calculated after
excluding depreciation on real estate, gain on asset sales and the
dilutive effects of the Series B preferred shares. As such, 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 to common
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 operating income because it is a noncash expense.
Gains are excluded because they are considered non-operating in nature
and because the Company has substantial capital loss carryforwards that
are expected to eliminate REIT distribution requirements resulting from
any gains realized through the year 2005. Operating income per 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.
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 (the "yield curve") and the extent the
Company continues to invest its liquidity in these portfolios. During 2001 and
thus far in 2002, the Company has not added significantly to these portfolios
while runoff has been relatively high resulting in declining financial asset
portfolio balances. Financial assets that have been acquired during this time
period have primarily consisted of adjustable-rate CMBS and other commercial
loans the earnings from which are less sensitive to changes in interest rates.
In addition, in May 2002 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 on the related debt are the responsibility of the
lessee. See
-22-
"Financial Condition - Mortgage Securities and Similar Investments" and "Real
Estate Held For Lease" for further discussion of the current operating
environment and the Company's goals regarding redeploying capital made available
by portfolio runoff.
Net margins on financial assets and related financing spreads (the difference
between yields earned on investments and the rates charged on related
borrowings) continue to benefit from actions taken by the Federal Reserve during
2001 to aggressively lower short-term interest rates, which resulted in
significantly lower interest rates on the Company's borrowings. However, lower
interest rates have also led to declining yields on the Company's
adjustable-rate assets and declining portfolio balances primarily caused by
higher mortgage prepayment rates. Net margins and spreads are expected to
continue declining as yields on the Company's ARM securities continue resetting
lower and portfolio balances continue declining because of relatively high
mortgage prepayments, in addition to scheduled principal payments and
maturities. Additionally, a strengthening U.S. economy may lead to increases in
short-term interest rates, which would likely result in higher borrowing costs
(see "Effects of Interest Rate Changes").
Agency Securities remained the primary contributor to operating results during
the quarter and six months ended June 30, 2002; however, the impact of lower
yields and a significantly lower average outstanding portfolio was evident in
the current quarter results which were less than the same period in 2001 despite
significantly lower borrowing rates. Year-to-date results still outpaced the
prior year. Yields for this portfolio averaged 5.32% and 5.47% during the
quarter and six months ended June 30, 2002, compared to 6.64% and 6.84% during
the same periods in 2001, while borrowing rates averaged 1.81% for both the
quarter and six months ended June 30, 2002 compared to 4.43% and 5.14% during
the same periods in 2001. The average outstanding Agency Securities portfolio
was $2.7 billion and $2.9 billion during the quarter and six months ended June
30, 2002 compared to $4.3 billion and $4.5 billion during the same periods in
2001.
Non-agency securities contributed less to operating results during the quarter
and six months ended June 30, 2002 than in the same periods in 2001 primarily
because of higher borrowing costs. Borrowing costs were higher because this
portfolio was funded almost entirely with equity during the first six months of
2001. Yields for this portfolio (calculated including mortgage insurance costs)
were lower averaging 5.68% and 5.92% during the quarter and six months ended
June 30, 2002, compared to 7.94% and 8.08% during the same periods in 2001,
while borrowing rates averaged 1.92% and 1.95% in 2002 compared to 3.78% and
5.01% in 2001. The average outstanding portfolio was $91 million and $90 million
during the quarter and six months ended June 30, 2002 compared to $101 million
and $96 million during the same periods in 2001. Borrowings averaged $47 million
and $50 million in 2002 compared to less than $5 million in 2001.
CMBS and other commercial loans contributed more to operating results during the
quarter and six months ended June 30, 2002 than in the same periods in 2001
primarily because of over $160 million in portfolio additions since December
2001. The average outstanding portfolio was nearly $200 million during both the
quarter and six months ended June 30, 2002 compared to less than $73 million
during the same periods in 2001. Borrowings averaged $172 million for both the
quarter and six months ended June 30, 2002 compared to $61 million during the
same periods in 2001. The portfolio yielded 5.00% and 4.73% during the quarter
and six months ended June 30, 2002 while borrowing rates averaged 2.52% and
2.46% producing financing spreads of 2.48% and 2.27%. This compares with yields
of 7.09% and 7.73% and borrowing rates of 5.05% and 5.70% for spreads of 2.04%
and 2.03% during the same periods in 2001. 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.
-23-
CMO collateral and investments contributed less to operating results primarily
because of higher prepayments on the underlying pledged CMO collateral. 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 provide
a positive return on capital employed in future periods (see "Financial
Condition - CMO Collateral and Investments").
Real estate held for lease results reflect ownership of these properties for two
months of the current quarter (see "Financial Condition - Real Estate Held For
Lease"). Revenue recognized through July 2002 consist of accruals under a
three-month rent concession with cash lease payments beginning in August 2002.
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.
With more stable short-term interest rates in 2002, current year earnings from
overnight investments recorded as other revenue have been lower than in 2001
when dramatic declines in interest rates created relatively wide positive
spreads between interest rates on overnight investments and short-term borrowing
rates.
Management and affiliate incentive fee accruals reflect current year
expectations for the amount the Company's performance will exceed predetermined
benchmarks established by members of the Board of Directors that are independent
of Fortress.
LIQUIDITY AND CAPITAL RESOURCES
Capstead's primary sources of funds include borrowings under repurchase
arrangements, other borrowings, monthly principal and interest payments on
mortgage securities and similar investments, excess cash flows on CMO collateral
and investments, payments received on real estate held for lease and proceeds
from asset sales (see "Financial Condition - Utilization of Capital and
Potential Liquidity"). The Company currently believes that these funds are
sufficient for the acquisition of real estate-related investments, repayments on
borrowings and the payment of cash dividends as required for Capstead's
continued qualification as a REIT. It is the Company'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. These
borrowings totaled approximately $2.5 billion at June 30, 2002. 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") rates 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 estate industries (see
"Effects of Interest Rate Changes").
Borrowings under repurchase arrangements with investment banking firms secured
by commercial mortgage securities and from commercial banks secured by
investments in commercial loans more 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, totaled
-24-
approximately $170 million at June 30, 2002. Should Capstead make significant
additional investments in credit-sensitive real estate-related assets, it is
anticipated that it will attempt to lessen interest rate volatility in a similar
fashion or through the use of derivative financial instruments ("Derivatives")
such as interest rate swaps (see "Effects of Interest Rate Changes" and "Risks
Associated With Credit-Sensitive Investments").
CMO borrowings totaled approximately $1.7 billion at June 30, 2002 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 on Capstead's
liquidity and capital resources. The maturity of each CMO series is affected by
mortgage prepayments and clean-up calls.
With its acquisition of senior living properties during the current quarter,
Capstead assumed approximately $20 million in mortgage financing from a
commercial bank that matures in 2009 and $101 million in tax-exempt bond debt
that matures in 2026. These bonds are expected to be refinanced prior to
year-end (see "Financial Condition - Real Estate Held For Lease").
EFFECTS OF INTEREST RATE CHANGES
INTEREST RATE SENSITIVITY ON OPERATING RESULTS
The Company 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, if any, are included in this analysis. The sensitivity of components of
Other revenue (expense) to changes in interest rates is included as well,
although no asset sales are assumed. 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 purchase premiums and CMO bond discounts. These assumptions are
developed through a combination of historical analysis and future expected
pricing behavior. As of June 30, 2002, Capstead had the following estimated
earnings sensitivity profile (dollars in thousands):
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%
Projected 12-month
earnings change:**
June 30, 2002 1.84% 4.80% $ 10,934 $14,859 $ 2,871 $(11,609)
December 31, 2001 1.87 5.05 12,380 18,023 3,196 (14,771)
* 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's financial capital plans.
These assumptions are inherently uncertain and, as a result, the model cannot
precisely estimate 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.
-25-
GENERAL DISCUSSION OF EFFECTS OF INTEREST RATE CHANGES
Changes in interest rates may affect Capstead'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
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 reset periodically based on underlying indices
(generally 1-year CMT rates). Since only a portion of the ARM loans underlying
these securities reset each month, 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, 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 the Company's borrowing
rates, earnings could be adversely affected. The Company may invest in
Derivatives from time to time as a hedge against rising interest rates on a
portion of its short-term borrowings. At June 30, 2002, the Company did not own
any Derivatives as a hedge against rising short-term interest rates.
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 interest 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's investment focus.
During periods of rising interest rates or contracting market liquidity, asset
values can decline leading to increased margin calls, reducing the Company'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.
-26-
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.
-27-
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' 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 could
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 the cost of
performing obligations (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
-28-
capital expenditures to remedy noncompliance. Existing requirements may
change and compliance 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.
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.
o An 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.
CRITICAL ACCOUNTING POLICIES
Management's discussion and analysis of financial condition and results of
operations is based upon Capstead'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.
-29-
Management believes the following are critical accounting policies in the
preparation of Capstead'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
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 11" 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").
FORWARD LOOKING STATEMENTS
This document contains "forward-looking statements" (within the meaning of the
Private Securities Litigation Reform Act of 1995) that inherently involve risks
and uncertainties. Capstead'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 the Company's investments and unforeseen factors.
Relative to the Company's investments in financial assets, these factors may
include, but are not limited to, changes in general economic conditions, the
availability of suitable investments, 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.
-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 Discussion and Analysis of
Financial Condition and Results of Operations."
PART II. -- OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits: The following Exhibit is presented herewith:
Exhibit 12 - Computation of Ratio of Earnings to Combined Fixed Charges
and Preferred Stock Dividends.
Exhibit 99.1 - Certification pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
(b) Reports on Form 8-K:
Current Report of Form 8-K dated May 1, 2002 announcing completed
acquisition of senior living properties.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
CAPSTEAD MORTGAGE CORPORATION
Date: August 12, 2002 By: /s/ ANDREW F. JACOBS
------------------------------------
Andrew F. Jacobs
Executive Vice President - Finance
Date: August 12, 2002 By: /s/ PHILLIP A. REINSCH
------------------------------------
Phillip A. Reinsch
Senior Vice President - Control
-31-
EXHIBIT INDEX
EXHIBIT
NUMBER DESCRIPTION
------- -----------
12 - Computation of Ratio of Earnings to Combined Fixed
Charges and Preferred Stock Dividends.
99.1 - Certification pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.