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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, 2003
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM ____________ TO ______________
COMMISSION FILE NUMBER: 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 [ ]
Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). 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) 14,013,559 as of August 7, 2003
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CAPSTEAD MORTGAGE CORPORATION
FORM 10-Q
FOR THE QUARTER ENDED JUNE 30, 2003
INDEX
PAGE
----
PART I. -- FINANCIAL INFORMATION
ITEM 1. Financial Statements
Consolidated Balance Sheets -- June 30, 2003 and December 31, 2002..................................... 3
Consolidated Statements of Operations -- Quarter and Six Months Ended
June 30, 2003 and 2002............................................................................... 4
Consolidated Statements of Cash Flows -- Six Months Ended June 30, 2003 and 2002....................... 5
Notes to Consolidated Financial Statements............................................................. 6
ITEM 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations............................................. 16
ITEM 3. Qualitative and Quantitative Disclosure of Market Risk...................................... 31
ITEM 4. Controls and Procedures..................................................................... 31
PART II. -- OTHER INFORMATION
ITEM 1. Legal Proceedings........................................................................... 31
ITEM 6. Exhibits and Reports on Form 8-K............................................................ 32
SIGNATURES................................................................................................ 32
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ITEM 1. FINANCIAL STATEMENTS
PART I. -- FINANCIAL INFORMATION
CAPSTEAD MORTGAGE CORPORATION
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
JUNE 30, 2003 DECEMBER 31, 2002
------------- -----------------
(UNAUDITED)
ASSETS
Mortgage securities and similar investments
($1.9 billion pledged under repurchase arrangements) $ 2,045,272 $ 2,431,519
CMO collateral and investments 541,346 1,083,421
----------- -----------
2,586,618 3,514,940
Real estate held for lease, net of accumulated depreciation 135,268 137,122
Receivables and other assets 68,358 55,863
Cash and cash equivalents 60,221 59,003
----------- -----------
$ 2,850,465 $ 3,766,928
=========== ===========
LIABILITIES
Repurchase arrangements and similar borrowings $ 1,881,631 $ 2,145,656
Collateralized mortgage obligations ("CMOs") 539,005 1,074,779
Borrowings secured by real estate 120,299 120,400
Incentive fee payable to management and affiliate 1,493 5,986
Common dividend payable 10,931 116,585
Accounts payable and accrued expenses 3,879 4,944
----------- -----------
2,557,238 3,468,350
----------- -----------
STOCKHOLDERS' EQUITY
Preferred stock - $0.10 par value; 100,000 shares authorized:
$1.60 Cumulative Preferred Stock, Series A,
214 and 219 shares issued and outstanding at
June 30, 2003 and December 31, 2002, respectively
($3,504 aggregate liquidation preference) 2,987 3,058
$1.26 Cumulative Convertible Preferred Stock, Series B,
15,819 and 15,820 shares issued and outstanding at
June 30, 2003 and December 31, 2002, respectively
($180,025 aggregate liquidation preference) 176,707 176,708
Common stock - $0.01 par value; 100,000 shares authorized;
14,014 and 13,962 shares issued and outstanding at
June 30, 2003 and December 31, 2002, respectively 140 140
Paid-in capital 457,715 458,919
Accumulated deficit (387,718) (387,718)
Accumulated other comprehensive income 43,396 47,471
----------- -----------
293,227 298,578
----------- -----------
$ 2,850,465 $ 3,766,928
=========== ===========
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
----------------------- -----------------------
2003 2002 2003 2002
---------- ---------- ---------- ----------
INTEREST INCOME:
Mortgage securities and similar investments $ 21,648 $ 40,067 $ 46,785 $ 85,835
CMO collateral and investments 10,122 30,696 25,090 68,130
--------- --------- --------- ---------
Total interest income 31,770 70,763 71,875 153,965
--------- --------- --------- ---------
INTEREST AND RELATED EXPENSE:
Repurchase arrangements and similar borrowings 6,454 12,965 13,673 27,011
CMO borrowings 10,010 30,979 25,349 68,965
Mortgage insurance and other 99 155 208 324
--------- --------- --------- ---------
Total interest and related expense 16,563 44,099 39,230 96,300
--------- --------- --------- ---------
Net margin on financial assets 15,207 26,664 32,645 57,665
--------- --------- --------- ---------
REAL ESTATE LEASE INCOME 2,575 2,187 5,096 2,187
--------- --------- --------- ---------
REAL ESTATE-RELATED EXPENSE:
Interest 1,133 1,296 2,225 1,296
Depreciation 927 642 1,854 642
--------- --------- --------- ---------
Total real estate-related expense 2,060 1,938 4,079 1,938
--------- --------- --------- ---------
Net margin on real estate held for lease 515 249 1,017 249
--------- --------- --------- ---------
OTHER REVENUE (EXPENSE):
Gain on asset sales and CMO redemptions 1,392 - 3,140 -
CMO administration and other 181 753 401 1,200
Management and affiliate incentive fee (587) (1,630) (1,493) (3,224)
Other operating expense (1,467) (1,450) (2,926) (2,929)
--------- --------- --------- ---------
Total other revenue (expense) (481) (2,327) (878) (4,953)
--------- --------- --------- ---------
NET INCOME $ 15,241 $ 24,586 $ 32,784 $ 52,961
========= ========= ========= =========
Net income $ 15,241 $ 24,586 $ 32,784 $ 52,961
Less cash dividends paid on preferred stock (5,068) (5,099) (10,138) (10,199)
--------- --------- --------- ---------
Net income available to common stockholders $ 10,173 $ 19,487 $ 22,646 $ 42,762
========= ========= ========= =========
NET INCOME PER COMMON SHARE:
Basic $ 0.73 $ 1.41 $ 1.62 $ 3.09
Diluted 0.65 1.24 1.41 2.67
CASH DIVIDENDS DECLARED PER SHARE:
Common $ 0.780 $ 1.430 $ 1.720 $ 3.080
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
---------------------------
2003 2002
------------ ------------
OPERATING ACTIVITIES:
Net income $ 32,784 $ 52,961
Noncash items:
Amortization of discount and premium 6,750 11,614
Depreciation and other amortization 2,542 1,447
Recognition of rent abatement 16 (2,187)
Gain on asset sales and CMO redemptions (3,140) -
Net change in prepaids, receivables, other assets,
accounts payable and accrued expenses (20,621) (12,013)
----------- -----------
Net cash provided by operating activities 18,331 51,822
----------- -----------
INVESTING ACTIVITIES:
Purchases of mortgage securities and similar investments (50,748) (89,226)
Purchase of real estate - (23,320)
Principal collections on mortgage securities
and similar investments 429,427 629,424
Proceeds from asset sales 76,055 -
CMO collateral:
Principal collections 463,782 578,226
Decrease in accrued interest receivable 3,129 3,515
----------- -----------
Net cash provided by investing activities 921,645 1,098,619
----------- -----------
FINANCING ACTIVITIES:
Decrease in repurchase arrangements and similar borrowings (264,025) (554,037)
Decrease in borrowings secured by real estate (101) (189)
CMO borrowings:
Principal payments on securities (532,030) (579,620)
Decrease in accrued interest payable (2,817) (3,239)
Capital stock transactions 70 191
Dividends paid (139,855) (33,130)
----------- -----------
Net cash used in financing activities (938,758) (1,170,024)
----------- -----------
Net change in cash and cash equivalents 1,218 (19,583)
Cash and cash equivalents at beginning of period 59,003 123,520
----------- -----------
Cash and cash equivalents at end of period $ 60,221 $ 103,937
=========== ===========
See accompanying notes to consolidated financial statements.
-5-
CAPSTEAD MORTGAGE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2003
(UNAUDITED)
NOTE 1 -- BUSINESS
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, single-family
residential adjustable-rate mortgage ("ARM") 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. Management believes that such investments, when
available at favorable prices and combined with the prudent use of leverage, can
produce attractive returns over the long term with less sensitivity to changes
in interest rates due largely to a higher risk of default and reduced liquidity
compared to Agency Securities.
Capstead's investment portfolios declined the last several years primarily
because of high levels of mortgage prepayments and a lack of suitable investment
opportunities at favorable prices. Consequently, in 2001 and again in January
2003 (with the payment of the fourth quarter 2002 common dividend), Capstead
returned a significant portion of its equity capital to its common stockholders.
To the extent proceeds of runoff or asset sales are not reinvested, or cannot be
reinvested, at a rate of return at least equal to the rate previously earned on
that capital, quarterly earnings and common dividends will likely continue
trending lower. The future size and composition of Capstead's investment
portfolios will depend on market conditions, including levels of mortgage
prepayments and the availability on a timely basis of suitable investments at
favorable prices.
NOTE 2 -- BASIS OF PRESENTATION
INTERIM FINANCIAL REPORTING
The accompanying unaudited consolidated financial statements have been prepared
in accordance with accounting principles generally accepted in the United States
("GAAP") for interim financial information and with the instructions to Form
10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of
the information and footnotes required by GAAP for complete financial
statements. In the opinion of management, all adjustments (consisting of normal
recurring accruals) considered necessary for a fair presentation have been
included. Operating results for the quarter and six months ended June 30, 2003
are not necessarily indicative of the results that may be expected for the
calendar year ending December 31, 2003. 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, 2002.
STOCK-BASED COMPENSATION
Compensation cost for stock-based awards for employees and directors is measured
as the excess, if any, of the quoted market price of the Company's stock at the
date of grant over the amount to be paid to acquire the stock and is recognized
in Other operating expense as the awards vest and restrictions lapse (the "APB25
intrinsic value method"). If the alternative fair value methodology included in
Statement of Accounting Standards No. 123 "Accounting for Stock-based
Compensation" were followed, reported net income would have been lower by less
than $25,000 per quarter, representing a zero to one cent impact on reported net
income per common share for the periods presented.
NOTE 3 -- 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, if any, by the weighted average number of common
shares and common share equivalents outstanding, giving effect to dilutive stock
options and dilutive convertible preferred shares. For dilutive net income per
share purposes, the Series A and B preferred shares are considered dilutive
whenever annualized basic net income per share exceeds each Series' annualized
-6-
dividend divided by the conversion rate applicable for that period. The
components of the computation of basic and diluted net income per share were as
follows (in thousands, except per share data):
QUARTER ENDED JUNE 30 SIX MONTHS ENDED JUNE 30
--------------------- ------------------------
2003 2002 2003 2002
--------- --------- --------- ---------
NUMERATOR FOR BASIC NET INCOME PER COMMON SHARE:
Net income $ 15,241 $ 24,586 $ 32,784 $ 52,961
Less all preferred share dividends (5,068) (5,099) (10,138) (10,199)
-------- -------- -------- --------
Net income available to common stockholders $ 10,173 $ 19,487 $ 22,646 $ 42,762
======== ======== ======== ========
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING 13,978 13,856 13,957 13,840
======== ======== ======== ========
BASIC NET INCOME PER COMMON SHARE $ 0.73 $ 1.41 $ 1.62 $ 3.09
======== ======== ======== ========
NUMERATOR FOR DILUTED NET INCOME PER COMMON SHARE:
Net income $ 15,241 $ 24,586 $ 32,784 $ 52,961
======== ======== ======== ========
DENOMINATOR FOR DILUTED NET INCOME PER COMMON SHARE:
Weighted average common shares outstanding 13,978 13,856 13,957 13,840
Net effect of dilutive stock options 35 56 41 65
Net effect of dilutive preferred shares * 9,257 5,901 9,242 5,901
-------- -------- -------- --------
23,270 19,813 23,240 19,806
======== ======== ======== ========
DILUTED NET INCOME PER COMMON SHARE $ 0.65 $ 1.24 $ 1.41 $ 2.67
======== ======== ======== ========
* The increase in net effect of dilutive preferred shares reflects, on a
weighted average basis, changes in preferred share conversion rates
resulting from the payment of common dividends in excess of net income
available to common stockholders. Current conversion rates are 1.4752
common shares for each Preferred A share and 0.5681 common shares for
each Preferred B share converted. It remains uneconomical to convert
the Series B preferred shares at current market prices of the common
and Series B preferred shares.
NOTE 4 -- MORTGAGE SECURITIES AND SIMILAR INVESTMENTS
The Company classifies its mortgage securities and similar investments by
collateral type and interest rate characteristics. Agency Securities are
AAA-rated and are considered to have limited credit risk. Non-agency securities
consist of private mortgage pass-through securities backed primarily by
single-family residential mortgage loans whereby the related credit risk of the
underlying loans is generally 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. Commercial
mortgage-backed securities ("CMBS") held by the Company as of June 30, 2003 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, 2003
consist of a loan to a joint venture that holds commercial real estate. The
maturity of mortgage securities is directly affected by the rate of principal
prepayments on the underlying loans.
Fixed-rate investments have fixed rates of interest and initial expected
weighted average lives of greater than five years. Adjustable-rate investments
have interest rates that adjust at least annually to more current interest
rates. For instance, mortgage loans underlying ARM securities either (i) adjust
annually based on a specified margin over the one-year Constant Maturity U.S.
Treasury Note Rate ("One-year CMT"), (ii) adjust semiannually based on a
specified margin over the six-month London Interbank Offered Rate ("LIBOR"), or
(iii) adjust monthly based on a specific margin over an index such as LIBOR or
the Cost of Funds Index as published by the Eleventh District Federal Reserve
Bank ("COFI"). In
-7-
addition, the terms of most ARM loans limit the amount of such adjustments
during any single interest rate adjustment period and over the life of the loan.
CMBS and commercial loans held as of June 30, 2003 adjust monthly based on a
specified margin over 30-day LIBOR.
Mortgage securities and similar investments and the related average effective
interest rates were as follows (dollars in thousands):
AVERAGE
PRINCIPAL PREMIUMS CARRYING COUPON AVERAGE
BALANCE (DISCOUNTS) BASIS AMOUNT (a) RATE (b) YIELD (b)
----------- ------------ ----------- ----------- -------- ---------
JUNE 30, 2003
Agency Securities:
Fannie Mae/Freddie Mac:
Fixed-rate $ 2,689 $ 16 $ 2,705 $ 2,810 10.00% 9.35%
LIBOR/CMT ARMs 960,496 13,603 974,099 996,558 4.21 3.67
COFI ARMs 108,969 (3,153) 105,816 111,000 3.81 4.86
Ginnie Mae ARMs 692,385 7,743 700,128 713,617 5.03 4.33
----------- ----------- ----------- -----------
1,764,539 18,209 1,782,748 1,823,985 4.52 4.01
Non-agency Securities (c) 109,650 2,006 111,656 112,802 5.01 3.81
CMBS (c) 72,716 (28) 72,688 72,700 2.29 3.47
Commercial loans (c) 35,759 26 35,785 35,785 8.50 8.47
----------- ----------- ----------- -----------
$ 1,982,664 $ 20,213 $ 2,002,877 $ 2,045,272 4.53 4.06
=========== =========== =========== ===========
DECEMBER 31, 2002
Agency Securities:
Fannie Mae/Freddie Mac:
Fixed-rate $ 3,628 $ 21 $ 3,649 $ 3,788 10.00% 9.48%
LIBOR/CMT ARMs 1,120,142 16,376 1,136,518 1,162,197 4.99 5.04
COFI ARMs 126,356 (3,655) 122,701 128,475 4.20 5.30
Ginnie Mae ARMs 881,911 9,767 891,678 904,470 5.36 5.25
----------- ----------- ----------- -----------
2,132,037 22,509 2,154,546 2,198,930 5.10 5.16
Non-agency Securities (c) 83,073 713 83,786 85,290 5.12 5.62
CMBS (c) 107,989 (309) 107,680 107,762 3.04 3.96
Commercial loans (c) 39,505 32 39,537 39,537 8.50 9.03
----------- ----------- ----------- -----------
$ 2,362,604 $ 22,945 $ 2,385,549 $ 2,431,519 5.07 5.17
=========== =========== =========== ===========
(a) Includes mark-to-market for securities classified as
available-for-sale, if applicable (see NOTE 10).
(b) Average Coupon Rate is presented as of the indicated balance sheet
date. Average Yield is presented for the quarter then ended, calculated
including amortization of premiums (discounts), mortgage insurance
costs on Non-agency Securities and excluding unrealized gains and
losses.
(c) As of the indicated dates, these portfolios consisted nearly
exclusively of adjustable-rate investments.
In connection with the formation of private mortgage pass-through securities
prior to 1995, the Company was required to establish reserve funds available to
pay special hazard (e.g. earthquake or mudslide-related losses) or certain
bankruptcy costs. The private mortgage pass-through securities were subsequently
held as Non-agency Securities, pledged as CMO collateral or sold to third
parties. As of June 30, 2003, included in Receivables and other assets as
restricted cash are $4.9 million in special hazard reserve funds and $1.2
million of bankruptcy reserve funds associated with $60.2 million and $63.7
million of loans outstanding, respectively.
-8-
NOTE 5 -- 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, 2003 DECEMBER 31, 2002
------------- -----------------
Pledged CMO Collateral:
Pledged mortgage securities $ 534,594 $1,066,734
Accrued interest receivable 3,202 6,325
---------- ----------
537,796 1,073,059
Unamortized premium 3,550 8,571
---------- ----------
541,346 1,081,630
CMO investments - 1,791
---------- ----------
$ 541,346 $1,083,421
========== ==========
Pledged mortgage securities are 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. With recent redemptions of previously-issued CMO
series, the Company no longer has credit risk held in the form of subordinate
bonds associated with Pledged CMO Collateral. The weighted average yield for
Pledged CMO Collateral and investments was 6.19% during the quarter ended June
30, 2003.
NOTE 6 -- REAL ESTATE HELD FOR LEASE
In May 2002 Capstead acquired six "independent" senior living facilities
(wherein the operator of the facility provides the tenants little, if any,
medical care) (the "Properties"). Concurrent with the acquisition, the Company
entered into a long-term "net-lease" arrangement with Brookdale Living
Communities, Inc. (collectively with its subsidiaries, "Brookdale"), under which
Brookdale is responsible for the ongoing operation and management of the
Properties. Brookdale, an owner, operator, developer and manager of senior
living facilities, is a majority-owned affiliate of Fortress Investment Group,
LLC (see NOTE 14).
The net-lease arrangement with Brookdale consists 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 in May 2007, 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 an amount representing an
attractive cash return on Capstead's equity in the Properties after payment of
monthly debt service. Because under the terms of the Lease Brookdale is
responsible for changes in related debt service requirements, earnings from the
Company's investment in net-leased real estate are generally not affected by
changes in interest rates.
-9-
Included in Receivables and other assets at June 30, 2003 are $3.2 million in
unamortized rent abatements and $1.5 million of other rent receivables due from
Brookdale. The components of real estate held for lease were as follows (in
thousands):
JUNE 30, 2003 DECEMBER 31, 2002
------------- -----------------
LAND $ 16,450 $ 16,450
Buildings 119,550 119,550
Equipment and fixtures 3,600 3,600
--------- ---------
139,600 139,600
Accumulated depreciation (4,332) (2,478)
--------- ---------
$ 135,268 $ 137,122
========= =========
NOTE 7 -- 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, 2003 DECEMBER 31, 2002
---------------------- --------------------
BORROWINGS AVERAGE BORROWINGS AVERAGE
OUTSTANDING RATE OUTSTANDING RATE
----------- ------- ----------- -------
Repurchase arrangements:
Agency Securities (less than 31 days) $ 1,704,699 1.12% $ 1,980,050 1.34%
Non-agency Securities (less than 31 days) 81,509 1.33 37,677 1.47
CMBS (greater than 90 days) 68,489 1.41 98,184 1.62
----------- -----------
1,854,697 1.14 2,115,911 1.36
Commercial bank borrowings 26,934 3.81 29,745 3.91
----------- -----------
$ 1,881,631 1.18 $ 2,145,656 1.39
=========== ===========
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, 2003 consist of an adjustable-rate loan that matures in January 2005
secured by a commercial loan investment. The terms and conditions of repurchase
arrangements and similar borrowings are negotiated on a
transaction-by-transaction basis. The weighted average effective interest rate
on repurchase arrangements and similar borrowings was 1.30% during the quarter
ended June 30, 2003.
NOTE 8 -- 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 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 is made
on any class of bonds until all classes having an earlier stated maturity have
been paid in full. The maturity of each CMO series is directly affected by the
rate of principal prepayments on the related Pledged CMO Collateral. Each series
is also subject to redemption provided that certain requirements specified in
the related indenture have been met (referred to as "Clean-up Calls");
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
6.08% during the quarter ended June 30, 2003.
-10-
The components of CMOs along with selected other information were as follows
(dollars in thousands):
JUNE 30, 2003 DECEMBER 31, 2002
--------------- -----------------
CMOs $ 533,339 $ 1,064,295
Accrued interest payable 2,968 5,785
--------------- ---------------
Total obligation 536,307 1,070,080
Unamortized premium 2,698 4,699
--------------- ---------------
$ 539,005 $ 1,074,779
=============== ===============
Range of average interest rates 1.40% to 9.42% 1.78% to 9.99%
Range of stated maturities 2009 to 2030 2008 to 2030
Number of series 13 17
NOTE 9 -- BORROWINGS SECURED BY REAL ESTATE
The components of borrowings secured by real estate and related weighted average
interest rates (calculated including bond issue cost amortization) for the dates
indicated were as follows (dollars in thousands):
JUNE 30, 2003 DECEMBER 31, 2002
---------------------- ---------------------
BORROWINGS AVERAGE BORROWINGS AVERAGE
OUTSTANDING RATE OUTSTANDING RATE
----------- -------- ----------- -------
Mortgage borrowings $ 19,458 7.92 $ 19,559 7.92%
Tax-exempt bonds 100,841 3.10 100,841 2.74
-------- --------
$120,299 3.88 $120,400 3.58
======== =======
Mortgage borrowings consist of a fixed-rate mortgage secured by one senior
living facility that matures in 2009. The tax-exempt bonds are credit-enhanced
by Fannie Mae and secured by mortgages on the remaining five senior living
facilities. Interest rates on the bonds adjust weekly based on the Bond Market
Association Municipal Swap Index ("BMA Index"). Interest rate cap agreements
with notional amounts aggregating $100.8 million, five-year terms and cap rates
equal to a 6% BMA Index are held to provide funds to pay interest on the bonds
in excess of a 6% BMA Index, should that occur. The interest rate cap agreements
were valued at $318,000 at June 30, 2003 and included in Receivables and other
assets. Monthly principal and interest rate cap reserve fund payments are made
to the trustee for the eventual retirement of the bonds by 2032 and the purchase
of new cap agreements in 2007.
In connection with the issuance of the bonds in November 2002, Capstead placed
into escrow with the trustee reserves for repairs and replacements totaling $2.7
million. During the six months ended June 30, 2003, the trustee released
$318,000 of these funds with the remainder expected to be released during 2003.
Another $6.0 million is held by the trustee in connection with Capstead posting
a $6.0 million letter of credit from a rated financial institution to
collateralize certain of the bonds. These funds, along with $724,000 of
principal and interest rate cap reserve funds, are included in Receivables and
other assets as restricted cash. Also included in Receivables and other assets
are $3.4 million in bond issue costs.
The weighted average effective interest rate for all borrowings secured by real
estate (calculated including bond issue cost amortization) was 3.78% for the
quarter ended June 30, 2003.
-11-
NOTE 10 -- 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 and CMBS 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 investments not held in the form of debt or equity securities
are excluded from these disclosures.
The following tables summarize fair value disclosures for available-for-sale
debt securities (in thousands):
GROSS GROSS
COST UNREALIZED UNREALIZED FAIR
BASIS GAINS LOSSES VALUE
----- ---------- ---------- ----------
AS OF JUNE 30, 2003
Agency Securities:
Fixed-rate $ 1,131 $ 105 $ - $ 1,236
ARMs 1,780,043 41,133 1 1,821,175
---------- ---------- -------- ----------
1,781,174 41,238 1 1,822,411
Non-agency Securities 70,483 1,146 - 71,629
CMBS 72,688 40 28 72,700
CMO collateral and investments 19,439 677 - 20,116
---------- ---------- -------- ----------
$1,943,784 $ 43,101 $ 29 $1,986,856
========== ========== ======== ==========
AS OF DECEMBER 31, 2002
Agency Securities:
Fixed-rate $ 1,505 $ 139 $ - $ 1,644
ARMs 2,150,897 44,251 6 2,195,142
---------- ---------- -------- ----------
2,152,402 44,390 6 2,196,786
Non-agency Securities 83,262 1,504 - 84,766
CMBS 107,680 112 30 107,762
CMO collateral and investments 26,943 873 2 27,814
---------- ---------- -------- ----------
$2,370,287 $ 46,879 $ 38 $2,417,128
========== ========== ======== ==========
Held-to-maturity debt securities consist of Pledged CMO Collateral and
collateral released from the related CMO indentures pursuant to Clean-up Calls
and held as Agency Securities and Non-agency Securities.
-12-
Fair value disclosures for debt securities held-to-maturity were as follows (in
thousands):
GROSS GROSS
COST UNREALIZED UNREALIZED FAIR
BASIS GAINS LOSSES VALUE
---------- ---------- ---------- ----------
AS OF JUNE 30, 2003
Released CMO Collateral:
Agency Securities $ 1,574 $ 143 $ - $ 1,717
Non-agency Securities 41,173 13 344 40,842
Pledged CMO Collateral 521,230 510 1,282 520,458
---------- --------- ---------- ----------
$ 563,977 $ 666 $ 1,626 $ 563,017
========== ========= ========== ==========
AS OF DECEMBER 31, 2002
Released CMO Collateral:
Agency Securities $ 2,144 $ 192 $ - $ 2,336
Non-agency Securities 524 52 - 576
Pledged CMO Collateral 1,055,607 795 4,639 1,051,763
---------- --------- ---------- ----------
$1,058,275 $ 1,039 $ 4,639 $1,054,675
========== ========= ========== ==========
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
--------------------- ------------------------
2003 2002 2003 2002
-------- -------- -------- -----------
Sale of securities held available-for-sale:
Amortized cost $ 22,208 $ - $ 50,748 $ -
Gain 818 - 1,831 -
Sale of released CMO collateral held-to-maturity:
Amortized cost 18,763 - 22,770 -
Gain 681 - 810 -
NOTE 11 -- 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 following table
provides information regarding comprehensive income (in thousands):
QUARTER ENDED SIX MONTHS ENDED
JUNE 30 JUNE 30
--------------------- ---------------------
2003 2002 2003 2002
-------- --------- -------- ---------
Net income $ 15,241 $ 24,586 $ 32,784 $ 52,961
Other comprehensive income (loss):
Unrealized gain on Derivatives held as cash flow hedges:
Change in unrealized gain during period (224) 46 (269) (58)
Reclassification adjustment for amounts
included in net income (10) (95) (37) (125)
-------- -------- -------- --------
(234) (49) (306) (183)
Unrealized gain on debt securities:
Change in unrealized gain during period (1,746) 935 (1,938) (4,134)
Reclassification adjustment for amounts
included in net income (818) - (1,831) -
-------- -------- -------- --------
Other comprehensive income (loss) (2,798) 886 (4,075) (4,317)
-------- -------- -------- --------
Comprehensive income $ 12,443 $ 25,472 $ 28,709 $ 48,644
======== ======== ======== ========
-13-
NOTE 12 -- NET INTEREST INCOME ANALYSIS
The following tables summarize interest income and interest expense and weighted
average interest rates pertaining to the Company's investments in financial
assets (excludes investments in real estate and related borrowings) (dollars in
thousands):
QUARTER ENDED JUNE 30
-----------------------------------------------------
2003 2002
--------------------- ------------------------
AVERAGE AVERAGE
AMOUNT RATE AMOUNT RATE
-------- ------- -------- -------
Interest income:
Mortgage securities and other investments $ 21,648 4.06% $ 40,067 5.31%
CMO collateral and investments 10,122 6.19 30,696 6.90
-------- --------
Total interest income 31,770 70,763
-------- --------
Interest expense:
Repurchase arrangements and similar
borrowings 6,454 1.30 12,965 1.85
CMO borrowings 10,010 6.08 30,979 7.01
-------- --------
Total interest expense 16,464 43,944
-------- --------
$ 15,306 $ 26,819
======== ========
SIX MONTHS ENDED JUNE 30
-----------------------------------------------------
2003 2002
--------------------- ------------------------
AMOUNT AVERAGE AMOUNT AVERAGE
-------- ------- -------- -------
Interest income:
Mortgage securities and similar investments $ 46,785 4.21% $ 85,835 5.44%
CMO collateral and investments 25,090 6.33 68,130 7.09
-------- --------
Total interest income 71,875 153,965
-------- --------
Interest expense:
Repurchase arrangements and similar
borrowings 13,673 1.32 27,011 1.85
CMOs borrowings 25,349 6.39 68,965 7.22
-------- --------
Total interest expense 39,022 95,976
-------- --------
$ 32,853 $ 57,989
======== ========
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, 2003
--------------------------------------
RATE* VOLUME* TOTAL
-------- --------- --------
Interest income:
Mortgage securities and similar investments $ (8,279) $ (10,140) $(18,419)
CMO collateral and investments (2,890) (17,684) (20,574)
-------- --------- --------
Total interest income (11,169) (27,824) (38,993)
-------- --------- --------
Interest expense:
Repurchase arrangements and similar
borrowings (3,290) (3,221) (6,511)
CMO borrowings (3,677) (17,292) (20,969)
-------- --------- --------
Total interest expense (6,967) (20,513) (27,480)
-------- --------- --------
$ (4,202) $ (7,311) $(11,513)
======== ========= ========
-14-
SIX MONTHS ENDED JUNE 30, 2003
---------------------------------
RATE* VOLUME* TOTAL
--------- --------- ---------
Interest income:
Mortgage securities and similar investments $(16,996) $(22,054) $(39,050)
CMO collateral and investments (6,620) (36,420) (43,040)
-------- -------- --------
Total interest income (23,616) (58,474) (82,090)
-------- -------- --------
Interest expense:
Repurchase arrangements and similar
borrowings (6,559) (6,779) (13,338)
CMO borrowings (7,150) (36,466) (43,616)
-------- -------- --------
Total interest expense (13,709) (43,245) (56,954)
-------- -------- --------
$ (9,907) $(15,229) $(25,136)
======== ======== ========
* The change in interest due to both volume and rate has been
allocated to volume and rate changes in proportion to the
relationship of the absolute dollar amounts of the change in
each.
NOTE 13 -- COMMITMENTS AND CONTINGENCIES
During 1998, twenty-four purported class action lawsuits were filed against
Capstead and certain of its officers alleging, among other things, that the
defendants violated federal securities laws by publicly issuing false and
misleading statements and omitting disclosure of material adverse information
regarding the Company's business. After these actions were consolidated and the
court appointed a lead plaintiff group, an amended complaint was filed in
October 2000. The amended complaint claims that as a result of alleged improper
actions, the market prices of the Company's equity securities were artificially
inflated during the period between April 17, 1997 and June 26, 1998 and seeks
monetary damages in an undetermined amount. In February 2001 the Company and
named officers responded to this amended complaint with motions to dismiss all
allegations against the Company and the named officers.
By order dated March 31, 2003, the court granted the Company and named officers'
motions to dismiss and entered an order dismissing the amended complaint and
denying the plaintiffs' request to further amend their complaint. On May 14,
2003 the plaintiffs filed a motion seeking to vacate this judgement and modify
this order to permit the filing of an amended complaint. On June 3, 2003 the
Company filed its brief in opposition to the plaintiffs' motion. Management
continues to believe the final resolution of this suit will not have a material
adverse effect on the financial position of the Company.
NOTE 14 -- TRANSACTIONS WITH FORMER AFFILIATES
Fortress Investment Group, LLC (together with its affiliates, "Fortress") was
Capstead's largest stockholder, holding approximately 26% of the outstanding
common shares as recently as December 31, 2002. Since year-end, Fortress has
sold its investment in Capstead. Pursuant to a management contract entered into
in April 2000, Fortress provided the services of Mr. Wesley R. Edens as
Capstead's chairman and chief executive and of other individuals as necessary to
perform support services for Mr. Edens. On July 22, 2003 Mr. Edens resigned from
his position with Capstead and the management contract with Fortress was
terminated. Under the terms of the contract, Fortress was entitled to a $375,000
base annual fee and participated with management in an incentive fee program
based on the Company's expected performance against predetermined benchmarks
established by members of the Board of Directors independent of Fortress.
Included in Other operating expense is $187,500 of base fees paid to Fortress
for services rendered during the six months ended June 30, 2003. In addition,
Fortress was awarded $500,000 of incentive fees from amounts accrued through
June 30, 2003 under this program. See NOTE 6 for information regarding Fortress'
involvement through its affiliate Brookdale in the acquisition and long-term
leasing of senior living facilities acquired by Capstead in 2002.
-15-
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
FINANCIAL CONDITION
OVERVIEW
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, single-family
residential adjustable-rate mortgage ("ARM") 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. Management believes that such investments, when
available at favorable prices and combined with the prudent use of leverage, can
produce attractive returns over the long term with less sensitivity to changes
in interest rates due largely to a higher risk of default and reduced liquidity
compared to Agency Securities.
Capstead's investment portfolios declined the last several years primarily
because of high levels of mortgage prepayments and a lack of suitable investment
opportunities at favorable prices. Consequently, in 2001 and again in January
2003 (with the payment of the fourth quarter 2002 common dividend), Capstead
returned a significant portion of its equity capital to its common stockholders.
To the extent proceeds of runoff or asset sales are not reinvested, or cannot be
reinvested, at a rate of return at least equal to the rate previously earned on
that capital, quarterly earnings and common dividends will likely continue
trending lower. The future size and composition of Capstead's investment
portfolios will depend on market conditions, including levels of mortgage
prepayments and the availability on a timely basis of suitable investments at
favorable prices (see "Effects of Interest Rate Changes," "Risks Associated with
Credit-Sensitive Investments" and "Risks Associated with Owning Real Estate").
MANAGEMENT CHANGES
Fortress Investment Group, LLC (together with its affiliates, "Fortress") was
Capstead's largest stockholder, holding approximately 26% of the outstanding
common shares as recently as December 31, 2002. Since year-end, Fortress has
sold its investment in Capstead. Pursuant to a management contract entered into
in April 2000, Fortress provided the services of Mr. Wesley R. Edens as
Capstead's chairman and chief executive and of other individuals as necessary to
perform support services for Mr. Edens. On July 22, 2003 Mr. Edens resigned from
his positions with Capstead and the management contract with Fortress was
terminated. Robert I. Kauffman, an associate of Mr. Edens and a director since
December 1999, also resigned effective July 22, 2003. Paul M. Low, one of
Capstead's founders and a long-time member of the Board of Directors, will
succeed Mr. Edens as Chairman. Andrew F. Jacobs, formerly Executive Vice
President and Chief Financial Officer, has been promoted to Chief Executive
Officer and President and has been elected to serve on the Board of Directors.
Phillip A. Reinsch, Senior Vice President - Control, has been promoted to Chief
Financial Officer.
BOOK VALUE PER COMMON SHARE
As of June 30, 2003, the Company's book value per common share was $7.83, a
decline of $0.40 from December 31, 2002 (calculated using the stated liquidation
preferences for Series A and B preferred shares). Book value declined primarily
because of dividend payments in excess of quarterly net income (approximately
$0.10 per share) and a reduction in the aggregate unrealized gain on the
Company's
-16-
investments (most of which are debt securities carried at fair value with
changes in fair value reflected in stockholders' equity) as a result of runoff
caused by mortgage prepayments. This unrealized gain can be expected to continue
to decline with runoff and to fluctuate with changes in interest rates and
market liquidity, and such changes will largely be reflected in book value per
common share. Book value will also be affected by other factors, including the
level of dividend distributions and depreciation charges on net-leased real
estate; however, temporary changes in fair values of investments not held in the
form of debt or equity securities generally will not affect book value.
MORTGAGE SECURITIES AND SIMILAR INVESTMENTS
As of June 30, 2003, mortgage securities and similar investments consisted
primarily of ARM Agency Securities (see "NOTE 4" to the accompanying
consolidated financial statements for discussion of how the Company classifies
its mortgage securities and similar 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 generally borne by AAA-rated private mortgage insurers
("Non-agency Securities"). In connection with the formation of private mortgage
pass-through securities prior to 1995, the Company was required to establish
reserve funds available to pay special hazard (e.g. earthquake or
mudslide-related losses) or certain bankruptcy costs. These securities were
subsequently held as Non-agency Securities, CMO collateral or sold to third
parties. Included in Receivables and other assets as restricted cash are $4.9
million in special hazard reserve funds and $1.2 million of bankruptcy reserve
funds associated with $60.2 million and $63.7 million of related loans
outstanding as of June 30, 2003, respectively. Commercial mortgage-backed
securitizations generally have senior, mezzanine and subordinate classes of
bonds with the lower classes providing credit enhancement to the more senior
classes. Commercial mortgage-backed securities ("CMBS") held by the Company at
June 30, 2003 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, 2003 consist of a 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 specific securities are pledged as collateral.
Capstead financed its commercial loan investment with a loan from a commercial
bank. Should the Company acquire additional financial assets 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, 2003 to $2.0 billion from $2.4 billion at
December 31, 2002, primarily as a result of portfolio runoff caused by mortgage
prepayments. Additions to this portfolio during the first six months of 2003
were limited to $123 million of mortgage securities released from CMO
indentures, $73 million of which were sold (see "CMO Collateral and
Investments"). To the extent the proceeds of mortgage prepayments and other
maturities are not reinvested or cannot be reinvested at a rate of return on
invested capital at least equal to the return earned on previous investments,
quarterly earnings and dividends will likely continue trending lower. 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 favorable prices (see "Effects of Interest Rate
Changes").
-17-
The following yield and cost analysis illustrates results achieved during the
second quarter of 2003 for components of the mortgage securities and similar
investments portfolio and anticipated third quarter 2003 asset yields and
borrowing rates based on interest rates in effect on July 22, 2003 (the date
second quarter 2003 results were released) (dollars in thousands):
2ND QUARTER AVERAGE (a) AS OF JUNE 30, 2003
--------------------------------- ------------------------ PROJECTED LIFETIME
ACTUAL ACTUAL PREMIUMS 3RD QUARTER PREPAYMENT
BASIS YIELD/COST RUNOFF (DISCOUNTS) BASIS (a) YIELD/COST (b) ASSUMPTIONS
----------- ---------- ------ ----------- ---------- -------------- -----------
Agency Securities:
Fannie Mae/Freddie Mac:
Fixed-rate $ 2,865 9.35% 43% $ 16 $ 2,705 9.69% 30%
ARMs:
LIBOR/CMT 1,019,003 3.67 27 13,603 974,099 3.40 25
COFI 111,468 4.86 28 (3,153) 105,816 4.70 25
Ginnie Mae ARMs 751,343 4.33 39 7,743 700,128 3.93 26
----------- --------- -----------
1,884,679 4.01 32 18,209 1,782,748 3.69 25
Non-agency Securities 131,379 3.81 35 2,006 111,656 4.51 40
CMBS and other
commercial loans 109,937 5.12 32 (2) 108,473 4.35 -
----------- --------- -----------
2,125,995 4.06 34 $ 20,213 2,002,877 3.80 25
=========
Borrowings 1,963,485 1.30 1,881,631 1.16
----------- -----------
Capital employed/
financing spread $ 162,510 2.76 $ 121,246 2.64
=========== ===========
Return on assets (c) 2.85
(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 2003 reflect ARM
coupon resets and lifetime prepayment assumptions as adjusted for
expected prepayments for this quarter only, as of July 22, 2003. 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 the portfolio averaged 4.06% during the second
quarter of 2003, a decline of 29 basis points from an average yield of 4.35%
earned during the previous quarter and 59 basis points from the average yield
earned during the fourth quarter of 2002. 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 current rates, the average yield on
the portfolio could decline approximately 64 basis points by the second quarter
of 2004. 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").
Average rates on related borrowings were 1.30% during the second quarter of
2003, a decline of four basis points from the first quarter. The June 25, 2003
action taken by the Federal Reserve to reduce the Federal Funds Rate by 25 basis
points is expected to lead to a 14 basis point decline in the Company's average
borrowing rates during the third quarter. Further declines in borrowing rates,
if any, are not expected to fully offset the effects on earnings of declining
portfolio yields and balances. The Company's
-18-
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. Credit
risk associated with pledged CMO collateral is borne by AAA-rated private
mortgage insurers or by subordinated bonds usually sold to investors. With
recent redemptions of previously-issued CMOs, the Company no longer has credit
risk held in the form of subordinated bonds associated with outstanding pledged
CMO collateral.
Most of the Company's securitizations have been afforded financing accounting
treatment with the related collateral recorded as pledged CMO collateral and the
outstanding bonds recorded as CMO liabilities (referred to as "financed CMOs").
Other securitizations issued by the Company in 1993 and prior were treated as
sales transactions (referred to as "sold CMOs"). Since 2000, the Company has not
issued 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. During the first half of 2003, the
Company exercised clean-up calls related to four financed CMOs and two sold
CMOs. The Company holds clean-up call rights on eight of its 13 remaining
financed CMOs and on its one remaining sold CMO. Although additional gains from
CMO redemptions could occur in the coming quarters, the amount and timing of any
such gains is dependent upon market conditions.
CMO collateral and investments, net of related bonds, was $2.3 million at June
30, 2003, down from $8.6 million at December 31, 2002. Included in this net
investment are $852,000 of 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
or included in the determination of gain (loss) on asset sales and CMO
redemptions (see "Effects of Interest Rate Changes").
REAL ESTATE HELD FOR LEASE
In May 2002 Capstead acquired six "independent" senior living properties
(wherein the operator of the facility provides the tenants little, if any,
medical care) (the "Properties"). The following table summarizes information
about the Properties:
YEAR
PROPERTY LOCATION UNITS (a) OCCUPANCY (b) OPENED
- ------------------------- ---------------- ------------------------- ------------- ------
Chambrel at Roswell Roswell, GA 280 (256 IL; 24 AL) 93.6% 1987
Chambrel at Pinecastle Ocala, FL 161 (120 IL; 41 AL) 96.9 1987
Chambrel at Island Lake Longwood, FL 269 (229 IL; 40 AL) 95.9 1985
Chambrel at Montrose Akron, OH 168 (136 IL; 32 AL) 97.0 1987
Chambrel at Williamsburg Williamsburg, VA 255 (200 IL; 55 AL) 98.0 1987
Chambrel at Club Hill Garland, TX 260 (192 IL; 68 AL) 88.8 1987
------------------------
Total 1,393 (1,133 IL; 260 AL) 94.8
========================
(a) IL refers to Independent Living units, AL refers to Assisted Living
units.
(b) As of June 30, 2003.
-19-
Concurrent with the acquisition of the Properties, the Company entered into a
long-term "net-lease" arrangement (the "Lease") with Brookdale Living
Communities, Inc. (collectively with its subsidiaries, "Brookdale"), under which
Brookdale is responsible for the ongoing operation and management of the
Properties. Brookdale, an owner, operator, developer and manager of senior
living facilities, is a majority-owned affiliate of Fortress. The Lease has an
initial term of 20 years and provides for two 10-year renewal periods. Beginning
in May 2007, Brookdale will have the option of purchasing all of the Properties
from Capstead at the greater of fair value or Capstead'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. 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").
UTILIZATION OF CAPITAL AND POTENTIAL LIQUIDITY
The following table illustrates Capstead's utilization of capital and potential
liquidity as of June 30, 2003 in comparison with December 31, 2002 (in
thousands):
CAPITAL POTENTIAL
ASSETS BORROWINGS EMPLOYED LIQUIDITY (a)
------------ ------------- ----------- -------------
Mortgage securities and similar investments:
Agency Securities $ 1,823,985 $ 1,704,699 $ 119,286 $ 65,316
Non-agency Securities 112,802 81,509 31,293 27,224
CMBS and other commercial loans 108,485 95,423 13,062 (317)
----------- ----------- ----------- -----------
2,045,272 1,881,631 163,641 92,223
CMO collateral and investments 541,346 539,005 2,341 -
Real estate held for lease 135,268 120,299 14,969 -
----------- ----------- ----------- -----------
$ 2,721,886 $ 2,540,935 180,951 92,223
=========== ===========
Other assets, net of other liabilities 123,207 60,221 (b)
Second quarter common dividend (10,931) (10,931)(c)
----------- ------------
$ 293,227 $ 141,513
----------- ------------
Balances as of December 31, 2002 $ 3,652,062 $ 3,340,835 $ 298,578 $ 143,033
=========== =========== =========== ============
(a) Based on maximum borrowings available under existing uncommitted
repurchase arrangements considering the fair value of related
collateral as of June 30, 2003 (see "Liquidity and Capital Resources").
(b) Represents unrestricted cash and cash equivalents.
(c) The second quarter common dividend was declared June 12, 2003 and paid
July 21, 2003 to stockholders of record as of June 30, 2003.
The Company generally finances its mortgage securities and similar investments
with repurchase arrangements and similar borrowings. CMO collateral is pledged
to secure CMO bonds. Real estate held for lease is financed by long-term
borrowings. Liquidity is affected by, among other things, changes in market
value of assets pledged under repurchase and similar 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").
-20-
RESULTS OF OPERATIONS
Comparative net operating results (interest income or lease revenue, net of
related interest expense, depreciation 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
-------------------- --------------------
2003 2002 2003 2002
-------- -------- -------- --------
Mortgage securities and similar investments:
Agency securities $ 13,195 $ 24,523 $ 28,981 $ 53,880
Non-agency Securities 1,029 1,062 2,074 2,169
CMBS and other commercial loans 903 1,429 1,917 2,601
CMO collateral and investments 80 (350) (327) (985)
-------- -------- -------- --------
Net margin on financial assets 15,207 26,664 32,645 57,665
-------- -------- -------- --------
Real estate held for lease:
Lease revenue net of related
interest expense 1,442 891 2,871 891
Real estate depreciation (927) (642) (1,854) (642)
-------- -------- -------- --------
Net margin on real estate held for lease 515 249 1,017 249
-------- -------- -------- --------
Other revenue (expense):
Gain on asset sales and CMO redemptions 1,392 - 3,140 -
CMO administration and other 181 753 401 1,200
Management and affiliate incentive fee (587) (1,630) (1,493) (3,224)
Other operating expense (1,467) (1,450) (2,926) (2,929)
-------- -------- -------- --------
Total other revenue (expense) (481) (2,327) (878) (4,953)
-------- -------- -------- --------
Net income $ 15,241 $ 24,586 $ 32,784 $ 52,961
======== ======== ======== ========
Net income per common share:
Basic $ 0.73 $ 1.41 $ 1.62 $ 3.09
Diluted 0.65 1.24 1.41 2.67
Operating * 0.68 1.43 1.50 3.08
* Capstead reports operating income per common share calculated
after excluding depreciation on real estate, gain on asset
sales and CMO redemptions, 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 the amount and timing of any such gains are dependent upon
market conditions. 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 (see "Comparison of Operating Income and
Diluted Income per Share").
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 the last
several years, the Company has not added significantly to these portfolios while
runoff has been relatively high resulting in declining financial asset portfolio
balances. Given a lack of suitable investment opportunities at attractive
prices, the Company instead returned a significant amount of its equity capital
to its common stockholders in 2001 and again in January 2003 (with the payment
of its fourth quarter 2002 common dividend). Financial assets that have been
acquired during this time period have primarily
-21-
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 "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) have declined steadily since peaking in early 2002 after having
benefited 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, more
significantly, declining portfolio balances primarily caused by relatively high
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 scheduled principal payments,
maturities and mortgage prepayments (see "Effects of Interest Rate Changes").
Agency Securities remained the primary contributor to operating results during
the quarter and six months ended June 30, 2003; however, the impact of lower
yields and a significantly lower average outstanding portfolio was evident in
current year results, which were significantly less than in the same periods in
2002 despite lower borrowing rates. Yields for this portfolio averaged 4.01% and
4.16% during the quarter and six months ended June 30, 2003, compared to 5.32%
and 5.47% during the same periods in 2002, while borrowing rates averaged 1.25%
and 1.27% for the quarter and six months ended June 30, 2003 compared to 1.81%
for both periods in 2002. The average outstanding Agency Securities portfolio
was $1.9 billion and $2.0 billion for the quarter and six months ended June 30,
2003 compared to $2.7 billion and $2.9 billion during the same periods in 2002.
Non-agency Securities contributed slightly less to operating results during the
quarter and six months ended June 30, 2003 compared to the same periods in 2002
primarily because declines in yields offset declines in borrowing rates and the
benefits of additional securities made available from the redemption of CMOs.
Yields for this portfolio (calculated including mortgage insurance costs) were
lower averaging 3.81% and 4.24% during the quarter and six months ended June 30,
2003 compared to 5.68% and 5.92% during the same periods in 2002, while
borrowing rates averaged 1.48% and 1.45% compared to 1.92% and 1.95% during the
same periods in 2002. The average outstanding portfolio was $131 million and
$115 million during the quarter and six months ended June 30, 2003 compared to
$91 million and $90 million during the same periods in 2002.
CMBS and other commercial loans contributed less to operating results during the
quarter and six months ended June 30, 2003 than in the same periods in 2002
primarily because of a lower average outstanding portfolio with payoffs during
2003 of several positions held by the Company throughout all of last year. The
average outstanding portfolio was $110 million and $126 million during the
quarter and six months ended June 30, 2003 compared to nearly $200 million for
both periods in 2002. The portfolio yielded 5.12% and 4.87% during the quarter
and six months ended June 30, 2003 while borrowing rates averaged 2.13% and
2.11% producing financing spreads of 2.99% and 2.76%. This compares with yields
of 5.00% and 4.73% and borrowing rates of 2.52% and 2.46% for spreads of 2.48%
and 2.27% during the same periods in 2002. Because this portfolio currently
consists of adjustable-rate assets secured by borrowings
-22-
with similar interest rate adjustment features, future changes in short-term
interest rates should have little effect on financing spreads.
The CMO collateral and investments portfolio has declined significantly the last
several years primarily because of high prepayments on the underlying pledged
CMO collateral and the exercise of clean-up calls in which the Company retires
the related bonds and either sells the released CMO collateral for gains or
holds it as Non-agency Securities. Without the issuance of CMOs in which the
Company retains residual interests, or the acquisition of other CMO investments,
this portfolio is not expected to contribute significantly to operating results
in future periods (see "Financial Condition - CMO Collateral and Investments").
Real estate held for lease was acquired May 1, 2002; therefore the quarter and
six months ended June 30, 2002 only includes two months ownership of these
properties (see "Financial Condition - Real Estate Held For Lease").
Gain on asset sales and CMO redemptions in the quarter and six months ended June
30, 2003 reflect the sale of $73 million of fixed-rate released CMO collateral
and a gain on the redemption of CMO bonds related to $49 million in
adjustable-rate collateral now held as Non-agency Securities. Although
additional gains from the redemption of previously-issued securitizations could
occur in the coming quarters, the amount and timing of any such gains are
dependent upon future market conditions.
CMO administration revenue continues to trend lower primarily because a
declining portfolio of CMOs for which the Company provides administrative
services. As these CMOs pay down, related fee income is expected to decline.
Other revenue was lower due to lower balances in overnight investments during
2003.
Management and affiliate incentive fee accruals reflect current year
expectations for the amount the Company's performance will exceed predetermined
benchmarks established at the beginning of the year by independent members of
the Board of Directors and includes $500,000 awarded Fortress for its services
prior to termination of its management contract in July. Lower current year
accruals reflect the recent trend of lower quarterly earnings and dividends (see
"Financial Condition - Overview" and "- Management Changes").
LIQUIDITY AND CAPITAL RESOURCES
Capstead's primary sources of funds are borrowings under repurchase arrangements
and monthly principal and interest payments on mortgage securities and similar
investments. Other sources of funds include proceeds from other borrowing
arrangements, proceeds from asset sales, payments received on real estate held
for lease, and excess cash flows on CMO collateral and investments. The Company
generally uses its liquidity to pay down borrowings to reduce borrowing costs.
The table included under "Financial Condition - Utilization of Capital and
Potential Liquidity" illustrates additional funds potentially available to the
Company as of June 30, 2003. The Company currently believes that it has ample
liquidity and capital resources available for the acquisition of additional
investments, repayments on borrowings, including the funding of CMO clean-up
calls, 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 $1.8 billion at June 30, 2003. Capstead has
uncommitted repurchase facilities with investment banking firms to finance
-23-
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 CMBS 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 approximately $95 million at June 30, 2003. Should
Capstead make significant additional investments in credit-sensitive 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 $539 million at June 30, 2003 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 in 2002, Capstead assumed
approximately $19 million in fixed-rate mortgage financing from a commercial
bank that matures in 2009 and $101 million in tax-exempt bond debt. In November
2002, the tax-exempt bonds were refunded with proceeds from issuing new 30-year
adjustable-rate tax-exempt bonds. Under the terms of the Lease, changes in
interest rates on this debt are the responsibility of the lessee and as such,
have no effect on the Company's liquidity (see "Financial Condition - Real
Estate Held For Lease").
EFFECTS OF INTEREST RATE CHANGES
INTEREST RATE SENSITIVITY ON OPERATING RESULTS
Capstead performs earnings sensitivity analysis using an income simulation model
to estimate the effects that specific interest rate changes can reasonably be
expected to have on future earnings. All financial assets and derivative
financial instruments ("Derivatives") held 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. Because under
the terms of the Lease, Brookdale is responsible for changes in related debt
service requirements, earnings from the Company's investment in net-leased real
estate are generally not affected by changes in interest rates. The model
incorporates management assumptions regarding the level of mortgage prepayments
for a given interest rate change using market-based estimates of prepayment
speeds for purposes of amortizing investment and liability premiums and
discounts. These assumptions are developed through a combination of historical
analysis and future
-24-
expected pricing behavior. As of June 30, 2003, 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, 2003 1.12% 3.52% 5,616 8,782 2,481 (6,995)
December 31, 2002 1.38 3.82 8,484 11,817 2,490 (9,665)
* 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.
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
financing spread may be reduced or even turn negative in a rising short-term
interest rate environment. Because the mortgage securities and similar
investments portfolio consists primarily of ARM securities, the risk of rising
short-term interest rates is offset to some extent by increases in the rates of
interest earned on the underlying ARM loans, which reset periodically based on
underlying indices (generally one-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,
2003, the Company did not own any Derivatives for this purpose.
Another effect of changes in interest rates is that as long-term interest rates
decrease, the rate of principal prepayments on mortgage loans underlying
mortgage securities and similar investments generally increases. During periods
of relatively low interest rates, prolonged periods of high prepayments can
significantly reduce the expected life of these investments; therefore, the
actual yields realized can be lower due to faster amortization of premiums.
Further, to the extent the proceeds of prepayments are not
-25-
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.
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
-26-
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.
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:
- - The risk that changes in economic conditions or real estate markets may
adversely affect the value of the properties.
- - During inflationary periods, which are generally accompanied by rising
interest rates, increases in operating costs and borrowing rates may be
greater than increases in lessee revenues from operating properties.
Over an extended period of time, this could result in lessee defaults.
- - The risk that a deterioration of local conditions could adversely
affect the ability of a lessee to profitably operate a property. For
instance, an oversupply of senior living properties could hamper the
leasing of senior living units at favorable rates. This could
ultimately affect the value of the properties.
- - Changes in tax, zoning or other laws could make properties less
attractive or less profitable.
- - An owner cannot be assured that lessees will elect to renew their
leases when the terms expire. If a lessee does not renew its lease or
otherwise defaults on its lease obligations, there is no assurance the
owner can obtain a substitute lessee on acceptable terms. If the owner
cannot obtain another qualified
-27-
operator to lease a property, the owner may be required to modify the
property for a different use, which may involve significant capital
expenditures and delays in re-leasing the property.
- - The risk that lessees will not perform under their leases, reducing the
owner's income from the leases or requiring the owner to assume costs
(such as real estate taxes, insurance, utilities and maintenance) that
are the lessees' responsibility under net-leases. In the case of
special-purpose real estate such as senior living facilities,
compliance with licensing requirements could complicate or delay the
transfer of operational control of such properties. This could lead to
a significant cash flow burden for the owner to service the debt and
otherwise maintain the properties.
- - Net-leases generally require the lessee to carry comprehensive
liability, casualty, workers' compensation and rental loss insurance.
The required coverage is typical of the type, and amount, customarily
obtained by an owner of similar properties. However, there are some
types of losses, such as catastrophic acts of nature, for which
insurance cannot be obtained at a commercially reasonable cost. If
there is an uninsured loss or a loss in excess of insurance limits, the
owner could lose both the revenues generated by the affected property
and the capital invested in the property. The owner would, however,
remain obligated to repay any mortgage indebtedness or other
obligations related to the property.
- - Investments in real estate are subject to various federal, state and
local regulatory requirements including the Americans with Disabilities
Act (the "ADA"). The ADA requires that public accommodations reasonably
accommodate individuals with disabilities and that new construction or
alterations be made to commercial facilities to conform to
accessibility guidelines. Failure to comply with the ADA can result in
injunctions, fines, and damage awards to private parties and additional
capital expenditures to remedy noncompliance. Existing requirements may
change and compliance with future requirements may involve significant
unanticipated expenditures. Although typically these expenditures would
be the responsibility of the lessee under the terms of net-leases, if
lessees fail to perform these obligations, the owner may be required to
do so.
- - Under federal, state and local environmental laws, the owner may be
required to investigate and clean up any release of hazardous or toxic
substances or petroleum products at its properties, regardless of its
knowledge or actual responsibility, simply because of current or past
ownership of the real estate. If unidentified environmental problems
arise, the owner may have to make substantial payments, which could
adversely affect cash flow and the ability to make distributions to
stockholders. This is so because:
1. The owner may have to pay for property damage and for
investigation and clean-up costs incurred in connection with
the contamination.
2. The law may impose clean-up responsibility and liability
regardless of whether the owner or operator knew of or caused
the contamination. Even if more than one person is responsible
for the contamination, each person who shares legal liability
under environmental laws may be held responsible for all of
the clean-up costs.
3. Governmental entities and third parties may sue the owner or
operator of a contaminated site for damages and costs.
In investigating the acquisition of real estate, environmental studies
are typically performed to establish the existence of any
contamination. In addition, net-leases generally require lessees to
operate properties in compliance with environmental laws and to
indemnify the owner against environmental liability arising from the
operation of such properties.
-28-
- - 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 AND ESTIMATES
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.
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:
- - Amortization of Premiums and Discounts on Financial Assets and
Borrowings - Premiums and discounts on financial assets and borrowings
are recognized in earnings as adjustments to interest income or
interest expense by the interest method over the estimated lives of the
related assets or borrowings. For most of Capstead's financial assets,
and for its CMO borrowings, estimates and judgments related to future
levels of mortgage prepayments are critical to this determination (see
"Effects of Interest Rate Changes").
- - Fair Value and Impairment Accounting for Financial Assets - Most of
Capstead's mortgage securities and similar investments portfolio and a
small portion of its CMO collateral and investments portfolio are
classified as held available-for-sale and recorded at fair value on the
balance sheet with unrealized gains and losses recorded in
stockholders' equity as a component of Accumulated other comprehensive
income. As such, these unrealized gains and losses enter into the
calculation of book value per common share. Generally, gains or losses
are recognized in earnings only if sold; however, if a decline in fair
value of an individual asset below its amortized cost occurs that is
determined to be other than temporary, the difference between amortized
cost and fair value would be included in Other revenue (expense) as an
impairment charge. Considerable judgment is required interpreting
market data to develop estimated fair values, particularly in
circumstances of deteriorating credit quality and market liquidity (see
"NOTE 10" to the accompanying consolidated financial statements for
discussion of how Capstead values its financial assets, "Risks of
Interest Rate Changes" and "Risks Associated with Credit-Sensitive
Investments").
- - 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
-29-
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.
COMPARISON OF OPERATING INCOME AND DILUTED INCOME PER SHARE
The following table compares the calculation of operating income and operating
income per common share to net income and diluted net income per share (in
thousands, except per share amounts):
QUARTER ENDED
------------------------------------------------------------------------------
JUNE 30, 2003 MARCH 31, 2003 JUNE 30, 2002
------------------------ ----------------------- ----------------------
OPERATING DILUTED OPERATING DILUTED OPERATING DILUTED
--------- ------- --------- -------- --------- --------
Net income $ 15,241 $ 15,241 $ 17,543 $ 17,543 $ 24,586 $ 24,586
Adjustments for:
Depreciation on real estate 927 - 927 - 642 -
Gain on asset sales and
CMO redemptions (1,393) - (1,748) - - -
Series B preferred dividends (4,982) - (4,983) - (4,990) -
-------- -------- -------- -------- -------- --------
$ 9,793 $ 15,241 $ 11,739 $ 17,543 $ 20,238 $ 24,586
======== ======== ======== ======== ======== ========
Weighted average common
shares outstanding 13,978 13,978 13,935 13,935 13,856 13,856
Net effect of dilutive securities:
Preferred B shares - 8,943 - 8,910 - 5,638
Stock options and other
preferred shares 349 349 407 407 319 319
-------- -------- -------- -------- -------- --------
14,327 23,270 14,342 23,252 14,175 19,813
======== ======== ======== ======== ======== ========
$ 0.68 $ 0.65 $ 0.82 $ 0.75 $ 1.43 $ 1.24
======== ======== ======== ======== ======== ========
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SIX MONTHS ENDED
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JUNE 30, 2003 JUNE 30, 2002
----------------------------- ---------------------------
OPERATING DILUTED OPERATING DILUTED
--------- ------- --------- -------
Net income $ 32,784 $ 32,784 $ 52,961 $ 52,961
Adjustments for:
Depreciation on real estate 1,854 - 642 -
Gain on asset sales and
CMO redemptions (3,140) - - -
Series B preferred dividends (9,965) - (9,981) -
-------- -------- -------- --------
$ 21,533 $ 32,784 $ 43,622 $ 52,961
======== ======== ======== ========
Weighted average common
shares outstanding 13,957 13,957 13,840 13,840
Net effect of dilutive securities:
Preferred B shares - 8,927 - 5,638
Stock options and other
preferred shares 356 356 328 328
-------- -------- -------- --------
14,313 23,240 14,168 19,806
======== ======== ======== ========
$ 1.50 $ 1.41 $ 3.08 $ 2.67
======== ======== ======== ========
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."
ITEM 4. CONTROLS AND PROCEDURES
As of June 30, 2003, an evaluation was performed under the supervision and with
the participation of the Company's management, including the Chief Executive
Officer ("CEO") and Executive Vice President - Finance ("CFO"), of the
effectiveness of the design and operation of the Company's disclosure controls
and procedures. Based on that evaluation, the Company's management, including
the CEO and CFO, concluded that the Company's disclosure controls and procedures
were effective as of June 30, 2003. There have been no significant changes in
the Company's internal controls or in other factors that could significantly
affect internal controls subsequent to June 30, 2003.
PART II. -- OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The information required by this item is included in NOTE 13 to the accompanying
unaudited interim financial statements and is incorporated herein by reference.
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ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits: The following Exhibits are presented herewith:
Exhibit 12 - Computation of Ratio of Earnings to Combined Fixed Charges
and Preferred Stock Dividends.
Exhibit 31.1 - Certification pursuant to Section 302(a) of the
Sarbanes-Oxley Act of 2002
Exhibit 32.1 - Certification pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
(b) Reports on Form 8-K:
Current Report on Form 8-K dated April 1, 2003 announcing ruling
received granting Capstead's motion to dismiss shareholder suit (see
ITEM 1. above).
Current Report on Form 8-K dated April 24, 2003 announcing first
quarter 2003 financial results.
Current Report on Form 8-K dated May 14, 2003 announcing plaintiff's
motion seeking to vacate the Court's March 31, 2003 judgement and
modify the Court's March 31, 2003 order to permit the filing of an
amended complaint (see ITEM 1. above).
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 7, 2003 By: /s/ ANDREW F. JACOBS
-------------------------------------
Andrew F. Jacobs
President and Chief Executive Officer
Date: August 7, 2003 By: /s/ PHILLIP A. REINSCH
-------------------------------------
Phillip A. Reinsch
Senior Vice President and
Chief Financial Officer
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