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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: SEPTEMBER 30, 2003
OR
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
- ----- EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM ____________ TO ______________
COMMISSION FILE NUMBER: 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) 14,016,803 as of November 5, 2003
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CAPSTEAD MORTGAGE CORPORATION
FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2003
INDEX
PART I. -- FINANCIAL INFORMATION
PAGE
----
ITEM 1. Financial Statements
Consolidated Balance Sheets -- September 30, 2003 and December 31, 2002................................ 3
Consolidated Statements of Operations -- Quarter and Nine Months Ended
September 30, 2003 and 2002.......................................................................... 4
Consolidated Statements of Cash Flows -- Nine Months Ended September 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............................................................ 31
SIGNATURES................................................................................................ 32
-2-
ITEM 1. FINANCIAL STATEMENTS
PART I. -- FINANCIAL INFORMATION
CAPSTEAD MORTGAGE CORPORATION
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
SEPTEMBER 30, 2003 DECEMBER 31, 2002
------------------ -----------------
(UNAUDITED)
ASSETS
Mortgage securities and similar investments
($2.0 billion pledged under repurchase arrangements) $ 2,120,974 $ 2,431,519
CMO collateral and investments 240,528 1,083,421
-------------- --------------
2,361,502 3,514,940
Real estate held for lease, net of accumulated depreciation 134,341 137,122
Receivables and other assets 58,474 55,863
Cash and cash equivalents 98,025 59,003
-------------- --------------
$ 2,652,342 $ 3,766,928
============== ==============
LIABILITIES
Repurchase arrangements and similar borrowings $ 1,994,389 $ 2,145,656
Collateralized mortgage obligations ("CMOs") 239,565 1,074,779
Borrowings secured by real estate 120,253 120,400
Incentive fee payable to former affiliate -- 4,982
Common stock dividend payable 10,513 116,585
Accounts payable and accrued expenses 5,281 5,948
-------------- --------------
2,370,001 3,468,350
-------------- --------------
STOCKHOLDERS' EQUITY
Preferred stock - $0.10 par value; 100,000 shares authorized:
$1.60 Cumulative Preferred Stock, Series A,
211 and 219 shares issued and outstanding at
September 30, 2003 and December 31, 2002,
respectively ($3,468 aggregate liquidation preference) 2,956 3,058
$1.26 Cumulative Convertible Preferred Stock, Series B,
15,819 and 15,820 shares issued and outstanding at
September 30, 2003 and December 31, 2002,
respectively ($180,025 aggregate liquidation preference) 176,707 176,708
Common stock - $0.01 par value; 100,000 shares authorized;
14,017 and 13,962 shares issued and outstanding at
September 30, 2003 and December 31, 2002, respectively 140 140
Paid-in capital 456,981 458,919
Accumulated deficit (387,718) (387,718)
Accumulated other comprehensive income 33,275 47,471
-------------- --------------
282,341 298,578
-------------- --------------
$ 2,652,342 $ 3,766,928
============== ==============
See accompanying notes to consolidated financial statements.
-3-
CAPSTEAD MORTGAGE CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
QUARTER ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
---------------------------- ----------------------------
2003 2002 2003 2002
------------ ------------ ------------ ------------
INTEREST INCOME:
Mortgage securities and similar investments $ 19,599 $ 34,866 $ 66,384 $ 120,701
CMO collateral and investments 5,971 26,316 31,061 94,446
------------ ------------ ------------ ------------
Total interest income 25,570 61,182 97,445 215,147
------------ ------------ ------------ ------------
INTEREST AND RELATED EXPENSE:
Repurchase arrangements and similar borrowings 5,377 11,886 19,050 38,897
CMO borrowings 5,803 26,594 31,152 95,559
Mortgage insurance and other 93 144 301 468
------------ ------------ ------------ ------------
Total interest and related expense 11,273 38,624 50,503 134,924
------------ ------------ ------------ ------------
Net margin on financial assets 14,297 22,558 46,942 80,223
------------ ------------ ------------ ------------
REAL ESTATE LEASE INCOME 2,468 3,219 7,564 5,406
------------ ------------ ------------ ------------
REAL ESTATE-RELATED EXPENSE:
Interest 1,046 1,918 3,271 3,214
Depreciation 927 962 2,781 1,604
------------ ------------ ------------ ------------
Total real estate-related expense 1,973 2,880 6,052 4,818
------------ ------------ ------------ ------------
Net margin on real estate held for lease 495 339 1,512 588
------------ ------------ ------------ ------------
OTHER REVENUE (EXPENSE):
Gain on asset sales and CMO redemptions 1,411 1,901 4,551 1,901
CMO administration and other 459 914 860 2,114
Incentive fee payable to former affiliate -- (1,351) (500) (4,034)
Other operating expense (1,883) (1,610) (5,802) (5,080)
------------ ------------ ------------ ------------
Total other revenue (expense) (13) (146) (891) (5,099)
------------ ------------ ------------ ------------
$ 14,779 $ 22,751 $ 47,563 $ 75,712
============ ============ ============ ============
NET INCOME
Net income $ 14,779 $ 22,751 $ 47,563 $ 75,712
Less cash dividends paid on preferred stock (5,068) (5,097) (15,204) (15,296)
------------ ------------ ------------ ------------
Net income available to common stockholders $ 9,711 $ 17,654 $ 32,359 $ 60,416
============ ============ ============ ============
NET INCOME PER COMMON SHARE:
Basic $ 0.69 $ 1.27 $ 2.32 $ 4.36
Diluted 0.63 1.15 2.04 3.82
CASH DIVIDENDS DECLARED PER SHARE:
Common $ 0.750 $ 1.320 $ 2.470 $ 4.440
Series A Preferred 0.400 0.400 1.200 1.200
Series B Preferred 0.315 0.315 0.945 0.945
See accompanying notes to consolidated financial statements.
-4-
CAPSTEAD MORTGAGE CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)
NINE MONTHS ENDED
SEPTEMBER 30
--------------------------------
2003 2002
-------------- --------------
OPERATING ACTIVITIES:
Net income $ 47,563 $ 75,712
Noncash items:
Amortization of discount and premium 9,185 17,699
Depreciation and other amortization 3,740 2,692
Recognition of rent abatement 58 (3,172)
Gain on asset sales and CMO redemptions (4,551) (1,901)
Net change in prepaids, receivables, other assets,
accounts payable and accrued expenses (7,388) (16,310)
-------------- --------------
Net cash provided by operating activities 48,607 74,720
-------------- --------------
INVESTING ACTIVITIES:
Purchases of mortgage securities and similar investments (235,028) (104,228)
Purchase of real estate -- (23,320)
Principal collections on mortgage securities
and similar investments 645,199 863,506
Proceeds from asset sales 123,543 16,901
CMO collateral:
Principal collections 594,113 794,826
Decrease in accrued interest receivable 3,382 4,801
-------------- --------------
Net cash provided by investing activities 1,131,209 1,552,486
-------------- --------------
FINANCING ACTIVITIES:
Decrease in repurchase arrangements and similar borrowings (151,267) (830,941)
Decrease in borrowings secured by real estate (147) (393)
CMO borrowings:
Principal payments on securities (829,111) (798,286)
Decrease in accrued interest payable (4,487) (4,458)
Capital stock transactions 70 190
Dividends paid (155,852) (58,105)
-------------- --------------
Net cash used in financing activities (1,140,794) (1,691,993)
-------------- --------------
Net change in cash and cash equivalents 39,022 (64,787)
Cash and cash equivalents at beginning of period 59,003 123,520
-------------- --------------
Cash and cash equivalents at end of period $ 98,025 $ 58,733
============== ==============
See accompanying notes to consolidated financial statements.
-5-
CAPSTEAD MORTGAGE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 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 fixed-rate and medium-term 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 may 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 nine months ended September 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.
-6-
RECLASSIFICATIONS
Certain prior period amounts have been reclassified to conform to the current
period presentation.
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
dividend divided by the conversion rate applicable for that period. The
components of the computation of basic and diluted net income per share were as
follows (in thousands, except per share data):
QUARTER ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
-------------------------- --------------------------
2003 2002 2003 2002
----------- ----------- ----------- -----------
NUMERATOR FOR BASIC NET INCOME PER COMMON SHARE:
Net income $ 14,779 $ 22,751 $ 47,563 $ 75,712
Less all preferred share dividends (5,068) (5,097) (15,204) (15,296)
----------- ----------- ----------- -----------
Net income available to common stockholders $ 9,711 $ 17,654 $ 32,359 $ 60,416
=========== =========== =========== ===========
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING 13,995 13,871 13,969 13,850
BASIC NET INCOME PER COMMON SHARE $ 0.69 $ 1.27 $ 2.32 $ 4.36
NUMERATOR FOR DILUTED NET INCOME PER COMMON SHARE:
Net income $ 14,779 $ 22,751 $ 47,563 $ 75,712
=========== =========== =========== ===========
DENOMINATOR FOR DILUTED NET INCOME PER COMMON SHARE:
Weighted average common shares outstanding 13,995 13,871 13,969 13,850
Net effect of dilutive stock options 38 50 35 59
Net effect of dilutive preferred shares * 9,302 5,898 9,263 5,901
----------- ----------- ----------- -----------
23,335 19,819 23,267 19,810
=========== =========== =========== ===========
DILUTED NET INCOME PER COMMON SHARE $ 0.63 $ 1.15 $ 2.04 $ 3.82
* The increase in net effect of dilutive preferred shares
reflects, on a weighted average basis, changes in preferred
share conversion rates resulting from the payment of common
dividends in excess of net income available to common
stockholders. Current conversion rates are 1.4818 common
shares for each Preferred A share and 0.5708 common shares for
each Preferred B share converted. It remains uneconomical to
convert the Series B preferred shares at current market prices
of the common and Series B preferred shares.
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 either borne by AAA-rated private mortgage insurers or by
the Company ("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 September 30, 2003
are mezzanine classes and therefore carry credit risk associated with the
underlying pools of commercial mortgage loans that is mitigated by
-7-
subordinate bonds held by other investors. Commercial loans held by the Company
as of September 30, 2003 consist of a loan to a joint venture that holds
commercial real estate. The maturity of mortgage securities is directly affected
by the rate of principal prepayments on the underlying loans.
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 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 September 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)
----------- ----------- ----------- ------------ ---------- -----------
SEPTEMBER 30, 2003
Agency Securities:
Fannie Mae/Freddie Mac:
Fixed-rate $ 2,350 $ 14 $ 2,364 $ 2,459 10.00% 9.41%
LIBOR/CMT ARMs 937,543 13,416 950,959 970,609 3.92 3.43
COFI ARMs 99,528 (2,878) 96,650 100,576 3.71 4.83
Ginnie Mae ARMs 706,595 7,639 714,234 721,676 4.58 3.85
----------- ----------- ----------- -----------
1,746,016 18,191 1,764,207 1,795,320 4.18 3.69
Non-agency Securities:
Fixed-rate 122,394 429 122,823 122,908 6.64 6.47
LIBOR/CMT ARMs 92,028 1,538 93,566 94,669 4.76 3.00
----------- ----------- ----------- -----------
214,422 1,967 216,389 217,577 5.82 4.68
CMBS (c) 72,587 (20) 72,567 72,587 2.17 2.21
Commercial loans (c) 35,469 21 35,490 35,490 8.50 8.45
----------- ----------- ----------- -----------
$ 2,068,494 $ 20,159 $ 2,088,653 $ 2,120,974 4.35 3.82
=========== =========== =========== ===========
DECEMBER 31, 2002
Agency Securities:
Fannie Mae/Freddie Mac:
Fixed-rate $ 3,628 $ 21 $ 3,649 $ 3,788 10.00% 9.48%
LIBOR/CMT ARMs 1,120,142 16,376 1,136,518 1,162,197 4.99 5.04
COFI ARMs 126,356 (3,655) 122,701 128,475 4.20 5.30
Ginnie Mae ARMs 881,911 9,767 891,678 904,470 5.36 5.25
----------- ----------- ----------- -----------
2,132,037 22,509 2,154,546 2,198,930 5.10 5.16
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.
-8-
In connection with the formation of private mortgage pass-through securities
prior to 1995, the Company was required to establish reserve funds available to
pay special hazard (e.g. earthquake or mudslide-related losses) or certain
bankruptcy costs. The private mortgage pass-through securities were subsequently
held as Non-agency Securities, pledged as CMO collateral or sold to third
parties. As of September 30, 2003, included in Receivables and other assets as
restricted cash are $4.9 million in special hazard reserve funds and $1.2
million of bankruptcy reserve funds associated with $55 million and $57 million
of loans outstanding, respectively.
NOTE 5 -- CMO COLLATERAL AND 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):
SEPTEMBER 30, 2003 DECEMBER 31, 2002
------------------ -----------------
Pledged CMO Collateral:
Pledged mortgage securities $ 237,269 $1,066,734
Accrued interest receivable 1,515 6,325
---------- ----------
238,784 1,073,059
Unamortized premium 1,744 8,571
---------- ----------
240,528 1,081,630
CMO investments -- 1,791
---------- ----------
$ 240,528 $1,083,421
========== ==========
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 was 5.99% during the quarter ended September 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
-9-
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.
Included in Receivables and other assets at September 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):
SEPTEMBER 30, 2003 DECEMBER 31, 2002
------------------ -----------------
Land $ 16,450 $ 16,450
Buildings 119,550 119,550
Equipment and fixtures 3,600 3,600
--------- ---------
139,600 139,600
Accumulated depreciation (5,259) (2,478)
--------- ---------
$ 134,341 $ 137,122
========= =========
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):
SEPTEMBER 30, 2003 DECEMBER 31, 2002
---------------------------- -----------------------------
BORROWINGS AVERAGE BORROWINGS AVERAGE
OUTSTANDING RATE OUTSTANDING RATE
--------------- --------- ------------- -----------
Repurchase arrangements:
Agency Securities (less than 31 days) $1,721,332 1.00% $1,980,050 1.34%
Non-agency Securities (less than 31 days) 178,548 1.52 37,677 1.47
CMBS (31 to 90 days) 68,274 1.30 98,184 1.62
---------- ----------
1,968,154 1.06 2,115,911 1.36
Commercial bank borrowings 26,235 3.63 29,745 3.91
---------- ----------
$1,994,389 1.09 $2,145,656 1.39
========== ==========
Borrowings 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 September 30, 2003 consist of an adjustable-rate loan that matures in January
2005 secured by a commercial loan investment. The terms and conditions of
repurchase arrangements and similar borrowings are negotiated on a
transaction-by-transaction basis. The weighted average effective interest rate
on repurchase arrangements and similar borrowings was 1.13% during the quarter
ended September 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
5.62% during the quarter ended September 30, 2003.
-10-
The components of CMOs along with selected other information were as follows
(dollars in thousands):
SEPTEMBER 30, 2003 DECEMBER 31, 2002
------------------ -----------------
CMOs $ 236,525 $1,064,295
Accrued interest payable 1,298 5,785
---------- ----------
Total obligation 237,823 1,070,080
Unamortized premium 1,742 4,699
---------- ----------
$ 239,565 $1,074,779
========== ==========
Range of average interest rates 1.48% to 9.43% 1.78% to 9.99%
Range of stated maturities 2024 to 2030 2008 to 2030
Number of series 7 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):
SEPTEMBER 30, 2003 DECEMBER 31, 2002
------------------------------ -------------------------------
BORROWINGS AVERAGE BORROWINGS AVERAGE
OUTSTANDING RATE OUTSTANDING RATE
------------- ---------- -------------- -----------
Mortgage borrowings $ 19,412 7.92% $ 19,559 7.92%
Tax-exempt bonds 100,841 2.83 100,841 2.74
-------- --------
$120,253 3.65 $120,400 3.58
======== ========
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 $403,000 at September 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 nine months ended September 30, 2003, the trustee released
$1.5 million of these funds. 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 $1.0 million 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 $3.3 million in bond issue costs.
The weighted average effective interest rate for all borrowings secured by real
estate (calculated including bond issue cost amortization) was 3.47% for the
quarter ended September 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 SEPTEMBER 30, 2003
Agency Securities:
Fixed-rate $ 1,023 $ 95 $ -- $ 1,118
ARMs 1,761,843 31,061 43 1,792,861
---------- ---------- ---------- ----------
1,762,866 31,156 43 1,793,979
Non-agency Securities:
Fixed-rate 2,369 85 -- 2,454
ARMs 64,323 1,104 1 65,426
---------- ---------- ---------- ----------
66,692 1,189 1 67,880
CMBS 72,567 32 12 72,587
CMO collateral and investments 18,006 585 -- 18,591
---------- ---------- ---------- ----------
$1,920,131 $ 32,962 $ 56 $1,953,037
========== ========== ========== ==========
AS OF DECEMBER 31, 2002
Agency Securities:
Fixed-rate $ 1,505 $ 139 $ -- $ 1,644
ARMs 2,150,897 44,251 6 2,195,142
---------- ---------- ---------- ----------
2,152,402 44,390 6 2,196,786
Non-agency Securities:
Fixed-rate -- -- -- --
ARMS 83,262 1,504 -- 84,766
---------- ---------- ---------- ----------
83,262 1,504 -- 84,766
CMBS 107,680 112 30 107,762
CMO collateral and investments 26,943 873 2 27,814
---------- ---------- ---------- ----------
$2,370,287 $ 46,879 $ 38 $2,417,128
========== ========== ========== ==========
Held-to-maturity debt securities consist of Pledged CMO Collateral and
collateral released from the related CMO indentures pursuant to Clean-up Calls
and held as Agency Securities and Non-agency Securities.
-12-
Fair value disclosures for debt securities held-to-maturity were as follows (in
thousands):
GROSS GROSS
COST UNREALIZED UNREALIZED FAIR
BASIS GAINS LOSSES VALUE
---------- ---------- ---------- ----------
AS OF SEPTEMBER 30, 2003
Released CMO Collateral:
Agency Securities $ 1,341 $ 121 $ -- $ 1,462
Non-agency Securities 149,697 3,749 293 153,153
Pledged CMO Collateral 221,937 293 43 222,187
---------- ---------- ---------- ----------
$ 372,975 $ 4,163 $ 336 $ 376,802
========== ========== ========== ==========
AS OF DECEMBER 31, 2002
Released CMO Collateral:
Agency Securities $ 2,144 $ 192 $ -- $ 2,336
Non-agency Securities 524 52 -- 576
Pledged CMO Collateral 1,055,607 795 4,639 1,051,763
---------- ---------- ---------- ----------
$1,058,275 $ 1,039 $ 4,639 $1,054,675
========== ========== ========== ==========
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 NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
-------------------------- --------------------------
2003 2002 2003 2002
---------- ---------- ---------- -----------
Sale of securities held available-for-sale:
Amortized cost $ 12,305 $ -- $ 63,053 $ --
Gain 183 -- 2,014 --
Sale of released CMO collateral held-to-maturity:
Amortized cost 33,964 -- 56,720 --
Gain 1,037 -- 1,846 --
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 NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
----------------------- -----------------------
2003 2002 2003 2002
-------- -------- -------- --------
Net income $ 14,779 $ 22,751 $ 47,563 $ 75,712
-------- -------- -------- --------
Other comprehensive income (loss):
Unrealized gain on Derivatives held as cash flow
hedges:
Change in unrealized gain during period 85 -- (184) (58)
Reclassification adjustment for amounts
included in net income (40) (52) (77) (177)
-------- -------- -------- --------
45 (52) (261) (235)
Unrealized gain on debt securities:
Change in unrealized gain during period (9,983) 1,913 (11,921) (2,221)
Reclassification adjustment for gain
included in net income (183) -- (2,014) --
-------- -------- -------- --------
Other comprehensive income (loss) (10,121) 1,861 (14,196) (2,456)
-------- -------- -------- --------
Comprehensive income $ 4,658 $ 24,612 $ 33,367 $ 73,256
======== ======== ======== ========
-13-
NOTE 12 -- NET INTEREST INCOME ANALYSIS
The following tables summarize interest income and interest expense and weighted
average interest rates pertaining to the Company's investments in financial
assets (excludes investments in real estate and related borrowings) (dollars in
thousands):
QUARTER ENDED SEPTEMBER 30
---------------------------------------------------------
2003 2002
-------------------------- ------------------------
AMOUNT AVERAGE AMOUNT AVERAGE
---------- --------- ---------- ---------
Interest income:
Mortgage securities and similar investments $ 19,599 3.82% $ 34,866 5.04%
CMO collateral and investments 5,971 5.99 26,316 6.73
---------- ----------
Total interest income 25,570 61,182
---------- ----------
Interest expense:
Repurchase arrangements and similar
borrowings 5,377 1.13 11,886 1.84
CMO borrowings 5,803 5.62 26,594 6.84
---------- ----------
Total interest expense 11,180 38,480
---------- ----------
$ 14,390 $ 22,702
========== ==========
NINE MONTHS ENDED SEPTEMBER 30
---------------------------------------------------------
2003 2002
-------------------------- ------------------------
AMOUNT AVERAGE AMOUNT AVERAGE
---------- --------- ---------- ---------
Interest income:
Mortgage securities and similar investments $ 66,384 4.09% $ 120,701 5.32%
CMO collateral and investments 31,061 6.26 94,446 6.98
---------- ----------
Total interest income 97,445 215,147
---------- ----------
Interest expense:
Repurchase arrangements and similar
borrowings 19,050 1.26 38,897 1.84
CMOs borrowings 31,152 6.24 95,559 7.11
---------- ----------
Total interest expense 50,202 134,456
---------- ----------
$ 47,243 $ 80,691
========== ==========
Changes in interest income and interest expense due to changes in interest rates
versus changes in volume were as follows (in thousands):
QUARTER ENDED SEPTEMBER 30, 2003
---------------------------------------------
RATE* VOLUME* TOTAL
----------- ----------- -----------
Interest income:
Mortgage securities and similar investments $ (7,442) $ (7,825) $ (15,267)
CMO collateral and investments (2,615) (17,730) (20,345)
----------- ----------- -----------
Total interest income (10,057) (25,555) (35,612)
----------- ----------- -----------
Interest expense:
Repurchase arrangements and similar
borrowings (3,866) (2,643) (6,509)
CMO borrowings (4,068) (16,723) (20,791)
----------- ----------- -----------
Total interest expense (7,934) (19,366) (27,300)
----------- ----------- -----------
$ (2,123) $ (6,189) $ (8,312)
=========== =========== ===========
-14-
NINE MONTHS ENDED SEPTEMBER 30, 2003
---------------------------------------------
RATE* VOLUME* TOTAL
----------- ----------- -----------
Interest income:
Mortgage securities and similar investments $ (24,509) $ (29,808) $ (54,317)
CMO collateral and investments (8,816) (54,569) (63,385)
----------- ----------- -----------
Total interest income (33,325) (84,377) (117,702)
----------- ----------- -----------
Interest expense:
Repurchase arrangements and similar
borrowings (10,444) (9,403) (19,847)
CMO borrowings (10,491) (53,916) (64,407)
----------- ----------- -----------
Total interest expense (20,935) (63,319) (84,254)
----------- ----------- -----------
$ (12,390) $ (21,058) $ (33,448)
=========== =========== ===========
* The change in interest due to both volume and rate has been
allocated to volume and rate changes in proportion to the
relationship of the absolute dollar amounts of the change in
each.
NOTE 13 -- COMMITMENTS AND CONTINGENCIES
During 1998, twenty-four purported class action lawsuits were filed against
Capstead and certain of its officers alleging, among other things, that the
defendants violated federal securities laws by publicly issuing false and
misleading statements and omitting disclosure of material adverse information
regarding the Company's business. After these actions were consolidated and the
court appointed a lead plaintiff group, an amended complaint was filed in
October 2000. The amended complaint claims that as a result of alleged improper
actions, the market prices of the Company's equity securities were artificially
inflated during the period between April 17, 1997 and June 26, 1998 and seeks
monetary damages in an undetermined amount. In February 2001, the Company and
named officers responded to this amended complaint with motions to dismiss all
allegations against the Company and the named officers.
By order dated March 31, 2003, the court granted the Company and named officers'
motions to dismiss and entered an order dismissing the amended complaint and
denying the plaintiffs' request to further amend their complaint. In early
November 2003, the plaintiff's opportunity to appeal this dismissal to the Fifth
Circuit Court of Appeals passed. With the dismissal of this case without appeal,
the Company expects to recover from its insurance carrier a $500,000 deductible
originally expensed in 1998 and 1999. This recovery will be recorded in Other
Revenue when received.
NOTE 14 -- TRANSACTIONS WITH FORMER 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 $210,000 of base fees paid to Fortress
for services rendered through July 22, 2003. In addition, Fortress was awarded
$500,000 of incentive fees from amounts accrued through that date under this
program. See NOTE 6 for information 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 fixed-rate or medium-term 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. By July 2003, Fortress 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, succeeded
Mr. Edens as Chairman. Andrew F. Jacobs, formerly Executive Vice President and
Chief Financial Officer, was promoted to Chief Executive Officer and President
and elected to serve on the Board of Directors. Phillip A. Reinsch, Senior Vice
President -- Control, was promoted to Chief Financial Officer.
BOOK VALUE PER COMMON SHARE
As of September 30, 2003, the Company's book value per common share was $7.05, a
decline of $0.78 during the current quarter and $1.18 since December 31, 2002.
Book value declined since year-end because of dividend payments in excess of
quarterly net income (approximately $0.16 per share) and, more significantly, a
reduction in the aggregate unrealized gain on the Company's investments (most of
which are debt securities carried at fair value with changes in fair value
reflected in stockholders'
-16-
equity) as a result of recent increases in interest rates and runoff caused by
mortgage prepayments. This unrealized gain can be expected to continue to
decline with runoff and to fluctuate with changes in interest rates and market
liquidity, and such changes will largely be reflected in book value per common
share. Book value will also be affected by other factors, including the level of
dividend distributions and depreciation charges on net-leased real estate;
however, temporary changes in fair values of investments not held in the form of
debt or equity securities generally will not affect book value.
MORTGAGE SECURITIES AND SIMILAR INVESTMENTS
As of September 30, 2003, mortgage securities and similar investments 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 either borne by AAA-rated private mortgage insurers or
by the Company ("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 $55 million and $57 million of related loans outstanding
as of September 30, 2003, respectively. Commercial mortgage-backed
securitizations generally have senior, mezzanine and subordinate classes of
bonds with the lower classes providing credit enhancement to the more senior
classes. Commercial mortgage-backed securities ("CMBS") held by the Company at
September 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 September 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").
Runoff caused by mortgage prepayments remains a significant challenge to
earnings generated by the Company's mortgage securities and similar investments.
After experiencing portfolio declines to nearly $2.0 billion at June 30, 2003
from $2.4 billion at December 31, 2002, during the third quarter the Company had
the opportunity to acquire $163 million in ARM Agency Securities at attractive
prices after sharp increases in medium and long-term interest rates in July and
August. In addition, during the third quarter Capstead transferred into this
portfolio $121 million in fixed-rate collateral released from financed CMOs that
the Company expects will earn improved financing spreads (the difference between
yields earned on investments and the rates charged on related borrowings) than
when financed by CMO bonds. Together, these additions more than offset third
quarter runoff such that the portfolio ended the quarter at $2.1 billion. Prior
to this third quarter activity, additions to this portfolio during 2003 were
limited to $49 million of adjustable-rate collateral released from financed
CMOs.
Interest rates declined again in September and although management believes
there may continue to be opportunities to acquire assets at attractive prices in
the near future, such acquisitions may not be sufficient to replace runoff. That
being said, runoff is expected to begin moderating in the fourth quarter as a
higher interest rate environment has reduced, if not eliminated, the opportunity
for homeowners to refinance their ARM loans into lower rate fixed-rate loans. To
the extent the proceeds of mortgage
-17-
prepayments and other maturities are not reinvested or cannot be reinvested at a
rate of return on invested capital at least equal to the return earned on
previous investments, quarterly earnings and dividends may 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").
The following yield and cost analysis illustrates results achieved during the
third quarter of 2003 for components of the mortgage securities and similar
investments portfolio and anticipated fourth quarter 2003 asset yields and
borrowing rates based on interest rates in effect on October 22, 2003 (the date
third quarter 2003 results were released) (dollars in thousands):
3RD QUARTER AVERAGE (a) AS OF SEPTEMBER 30, 2003
------------------------------------- ---------------------------- PROJECTED LIFETIME
ACTUAL ACTUAL PREMIUMS 4TH QUARTER PREPAYMENT
BASIS YIELD/COST RUNOFF (DISCOUNTS) BASIS (a) YIELD/COST (b) ASSUMPTIONS
------------ ------------ --------- ------------- ------------ -------------- -------------
Agency Securities:
Fannie Mae/Freddie Mac:
Fixed-rate $ 2,566 9.41% 39% $ 14 $ 2,364 9.50% 30%
ARMs:
LIBOR/CMT 945,915 3.43 29 13,416 950,959 3.18 25
COFI 102,189 4.83 30 (2,878) 96,650 4.64 25
Ginnie Mae ARMs 685,978 3.85 43 7,639 714,234 3.64 26
---------- ---------- ----------
1,736,648 3.69 35 18,191 1,764,207 3.45 25
Non-agency Securities:
Fixed-rate 97,189 6.47 30 429 122,823 6.22 32
ARMs 103,099 3.00 50 1,538 93,566 3.37 40
---------- ---------- ----------
200,288 4.68 41 1,967 216,389 5.10 35
CMBS and other
commercial loans 108,273 4.27 2 1 108,057 4.28 --
---------- ---------- ----------
2,045,209 3.82 35 $ 20,159 $2,088,653 3.67 25
==========
Borrowings 1,865,726 1.13 1,994,389 1.15
---------- ----------
Capital employed/
financing spread $ 179,483 2.69 $ 94,264 2.52
========== ==========
Return on assets (c) 2.77 2.60
(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 fourth quarter of 2003 reflect ARM
coupon resets and lifetime prepayment assumptions as adjusted for
expected prepayments for this quarter only, as of October 22, 2003.
Actual yields realized in future periods will largely depend upon (i)
changes 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 3.82% during the third
quarter of 2003, a decline of 24 basis points from an average yield of 4.06%
earned during the previous quarter and 83 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 rates in effect October 22, 2003,
the average yield on the portfolio could decline approximately 38 basis points
by the third 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").
-18-
Average rates on related borrowings were 1.13% during the third quarter of 2003,
a decline of 17 basis points from the second quarter and 49 basis points from
average borrowing rates incurred during the fourth quarter of 2002. The
Company's borrowing rates depend on actions by the Federal Reserve to change
short-term interest rates, market expectations of future changes in short-term
interest rates and the extent of changes in financial market liquidity (see
"Effects of Interest Rate Changes").
CMO COLLATERAL AND INVESTMENTS
Since exiting the residential mortgage loan conduit business in 1995, Capstead
has maintained finance subsidiaries with capacity to issue CMOs and other
securitizations backed by single-family residential mortgage loans. From time to
time, the Company may purchase mortgage loans from originators or conduits,
place these loans into private mortgage pass-through securities and issue CMOs
or other securities backed by these securities. The Company may or may not
retain a significant residual economic interest in these securitizations. 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 has exercised its right to
redeem previously issued CMOs (referred to as "clean-up calls") and has either
sold or transferred the released collateral to the Non-agency Securities
portfolio where it has been held for investment. During the first nine months of
2003, the Company exercised clean-up calls related to ten financed CMOs and
three sold CMOs. As of September 30, 2003, the Company holds clean-up call
rights on two of its seven remaining financed CMOs. Consequently, additional
significant gains from CMO redemptions are not expected to occur in the coming
quarters.
CMO collateral and investments, net of related bonds, declined from $8.6 million
at year-end to $963,000 at September 30, 2003, as a result of portfolio runoff
and exercising clean-up calls as discussed above. Without the issuance of CMOs
in which the Company retains residual interests, or the acquisition of other CMO
investments, this portfolio is not expected to contribute significantly to
operating results in future periods.
REAL ESTATE HELD FOR 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) 95.7% 1987
Chambrel at Pinecastle Ocala, FL 161 (120 IL; 41 AL) 98.8 1987
Chambrel at Island Lake Longwood, FL 269 (229 IL; 40 AL) 97.4 1985
Chambrel at Montrose Akron, OH 168 (136 IL; 32 AL) 98.8 1987
Chambrel at Williamsburg Williamsburg, VA 255 (200 IL; 55 AL) 98.4 1987
Chambrel at Club Hill Garland, TX 260 (192 IL; 68 AL) 92.3 1987
------------------------
Total 1,393 (1,133 IL; 260 AL) 96.6
========================
(a) IL refers to Independent Living units, AL refers to Assisted Living units.
(b) As of September 30, 2003.
-19-
Concurrent with the acquisition of the Properties, the Company entered into a
long-term "net-lease" 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 September 30, 2003 in comparison with December 31, 2002 (in
thousands):
CAPITAL POTENTIAL
ASSETS BORROWINGS EMPLOYED LIQUIDITY (a)
---------- ---------- ---------- -------------
Mortgage securities and similar investments:
Agency Securities $1,795,320 $1,721,332 $ 73,988 $ 21,068
Non-agency Securities 217,577 178,548 39,029 32,823
CMBS and other commercial loans 108,077 94,509 13,568 327
---------- ---------- ---------- ----------
2,120,974 1,994,389 126,585 54,218
CMO collateral and investments 240,528 239,565 963 --
Real estate held for lease 134,341 120,253 14,088 --
---------- ---------- ---------- ----------
$2,495,843 $2,354,207 141,636 54,218
========== ==========
Other assets, net of other liabilities 151,218 98,025(b)
Second quarter common dividend (10,513) (10,513)(c)
---------- ----------
$ 282,341 $ 141,730
========== ==========
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 September 30, 2003 (see "Liquidity and Capital
Resources").
(b) Represents unrestricted cash and cash equivalents.
(c) The third quarter common dividend was declared September 11, 2003 and
paid October 21, 2003 to stockholders of record as of September 30,
2003.
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, real estate 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 NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
-------------------- --------------------
2003 2002 2003 2002
-------- -------- -------- --------
Mortgage securities and similar investments:
Agency securities $ 11,476 $ 20,247 $ 40,457 $ 74,127
Non-agency Securities 1,974 890 4,048 3,059
CMBS and other commercial loans 710 1,762 2,627 4,363
CMO collateral and investments 137 (341) (190) (1,326)
-------- -------- -------- --------
Net margin on financial assets 14,297 22,558 46,942 80,223
-------- -------- -------- --------
Real estate held for lease:
Lease revenue net of related
interest expense 1,422 1,301 4,293 2,192
Real estate depreciation (927) (962) (2,781) (1,604)
-------- -------- -------- --------
Net margin on real estate held for lease 495 339 1,512 588
-------- -------- -------- --------
Other revenue (expense):
Gain on asset sales and CMO redemptions 1,411 1,901 4,551 1,901
CMO administration and other 459 914 860 2,114
Incentive fee payable to former affiliate -- (1,351) (500) (4,034)
Other operating expense (1,883) (1,610) (5,802) (5,080)
-------- -------- -------- --------
Total other revenue (expense) (13) (146) (891) (5,099)
-------- -------- -------- --------
Net income $ 14,779 $ 22,751 $ 47,563 $ 75,712
======== ======== ======== ========
Net income per common share:
Basic $ 0.69 $ 1.27 $ 2.32 $ 4.36
Diluted 0.63 1.15 2.04 3.82
Operating * 0.65 1.19 2.15 4.27
* Capstead reports operating income per common share (a non-GAAP
financial measure calculated excluding depreciation on real
estate, gain on asset sales and CMO redemptions, and the dilutive
effects of the Series B preferred share) under the belief it
provides investors with a useful supplemental measure of the
Company's operating performance. Depreciation on real estate,
although an expense deductible for federal income tax purposes and
therefore an item that reduces Capstead's REIT distribution
requirements, is added back to arrive at operating income because
it is a noncash expense. Gains are excluded because they are
considered non-operating in nature and the amount and timing of
any such gains are dependent upon market conditions. Operating
income per common share excludes the dilutive effects of the
Series B preferred shares because it is not economically
advantageous to convert these shares at the current market prices
of both the common shares and Series B preferred shares (see
"Comparison of Operating Income and Diluted Income per Common
Share").
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. Net margins on
financial assets and related financing spreads 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
-21-
and, more significantly, declining portfolio balances primarily caused by
relatively high mortgage prepayment rates. Net margins and spreads may continue
declining as yields on the Company's ARM securities continue resetting lower,
particularly if declines in portfolio balances because of scheduled principal
payments, maturities and mortgage prepayments are not offset by acquisitions of
new mortgage assets (see "Effects of Interest Rate Changes").
Agency Securities remained the primary contributor to operating results during
the quarter and nine months ended September 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 3.69%
and 4.02% during the quarter and nine months ended September 30, 2003, compared
to 4.99% and 5.32% during the same periods in 2002, while borrowing rates
averaged 1.06% and 1.21% for the quarter and nine months ended September 30,
2003 compared to 1.79% and 1.80% during the same periods in 2002. The average
outstanding Agency Securities portfolio was $1.7 billion and $1.9 billion for
the quarter and nine months ended September 30, 2003 compared to $2.5 billion
and $2.7 billion during the same periods in 2002.
Non-agency Securities contributed more to operating results during the quarter
and nine months ended September 30, 2003 compared to the same periods in 2002
primarily because of the benefits of additional securities made available from
the redemption of CMOs. The average outstanding portfolio was $200 million and
$144 million during the quarter and nine months ended September 30, 2003
compared to $83 million and $88 million during the same periods in 2002. Yields
for this portfolio (calculated including mortgage insurance costs) were lower
averaging 4.68% and 4.45% during the quarter and nine months ended September 30,
2003 compared to 5.25% and 5.71% during the same periods in 2002, while
borrowing rates averaged 1.45% for both the current quarter and year-to-date
periods compared to 1.87% and 1.92% during the same periods in 2002.
CMBS and other commercial loans contributed less to operating results during the
quarter and nine months ended September 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 $108 million and $120 million during
the quarter and nine months ended September 30, 2003 compared to $199 million
for both periods in 2002. The portfolio yielded 4.27% and 4.69% during the
quarter and nine months ended September 30, 2003 while borrowing rates averaged
1.95% and 2.06% producing financing spreads of 2.32% and 2.63%, respectively.
This compares with yields of 5.56% and 5.01% and borrowing rates of 2.50% and
2.48% for spreads of 3.06% and 2.53%, respectively, during the same periods in
2002. Because this portfolio currently consists of adjustable-rate assets
secured by borrowings with similar interest rate adjustment features, future
changes in short-term interest rates should have little effect on financing
spreads.
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 retired
the related bonds and either sold the released CMO collateral for gains or
transferred it into the Non-agency Securities portfolio where it is held for
investment (see "Financial Condition -- CMO Collateral and Investments").
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. Current
quarter results were higher than the third quarter of 2002 primarily because of
an annual rent escalation effective each May 1 and lower depreciation expense
because of the October 2002 sale of a skilled nursing facility acquired with
these six independent living properties. Because real estate
-22-
held for lease was acquired May 1, 2002, the nine months ended September 30,
2002 only includes five months ownership of these properties (see "Financial
Condition -- Real Estate Held For Lease").
Gain on asset sales and CMO redemptions reflect the sale of $120 million of
released CMO collateral and gains on the redemption of CMO bonds related to $170
million in collateral held as Non-agency securities upon release from the
related indentures. The Company does not anticipate realizing significant
additional gains from the redemption of previously-issued securitizations.
CMO administration revenue continues to trend lower primarily because a
declining portfolio of CMOs for which the Company provides administrative
services. As these CMOs pay down, related fee income is expected to decline.
Other revenue was lower due to lower balances in overnight investments during
2003.
On a combined basis, incentive fees payable to Fortress, the Company's former
affiliate, and other operating expenses were considerably less during the
quarter and nine months ended September 30, 2003 than during the same periods in
2002. This reflects lower current year accruals for incentive fees payable to
management and Fortress primarily because of the recent trend of lower quarterly
earnings and dividends (see "Financial Condition -- 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 September 30, 2003. The Company currently believes that it has
ample liquidity and capital resources available for the acquisition of
additional investments, repayments on borrowings and the payment of cash
dividends as required 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 $1.9 billion at September 30, 2003. Capstead
has uncommitted repurchase facilities with investment banking firms to finance
these investments, subject to certain conditions. Interest rates on these
borrowings are generally based on 30-day London Interbank Offered Rate ("LIBOR")
rates and related terms and conditions are negotiated on a
transaction-by-transaction basis. Amounts available to be borrowed under these
arrangements are dependent upon the fair value of the securities pledged as
collateral, which fluctuates with changes in interest rates, credit quality and
liquidity conditions within the investment banking, mortgage finance and real
estate industries (see "Effects of Interest Rate Changes").
Borrowings under repurchase arrangements with investment banking firms secured
by 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 September 30, 2003. Should
Capstead make significant additional investments in credit-
-23-
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 $240 million at September 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 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 expected pricing
behavior. As of September 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:
September 30, 2003 1.12% 3.94% $7,491 $10,517 $2,172 $(9,143)
December 31, 2002 1.38 3.82 8,484 11,817 2,490 (9,665)
* 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
-24-
net margins or precisely predict the impact of higher or lower interest rates on
net margins. Actual results will differ from simulated results due to timing,
magnitude and frequency of interest rate changes and other changes in market
conditions, management strategies and other factors.
GENERAL DISCUSSION OF EFFECTS OF INTEREST RATE CHANGES
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 September
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 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.
-25-
RISKS ASSOCIATED WITH CREDIT-SENSITIVE INVESTMENTS
Commercial mortgage assets may be viewed as exposing an investor to greater risk
of loss than residential mortgage assets since such assets are typically secured
by larger loans to fewer obligors than residential mortgage assets. Commercial
property values and related net operating income are often subject to
volatility, and net operating income may be sufficient or insufficient to cover
debt service on the related mortgage loan at any given time. The repayment of
loans secured by income-producing properties is typically dependent upon the
successful operation of the related real estate project and the ability of the
applicable property to produce net operating income rather than upon the
liquidation value of the underlying real estate. Even when the current net
operating income is sufficient to cover debt service, there can be no assurance
that this will continue to be the case in the future.
Additionally, commercial properties may not be readily convertible to
alternative uses if such properties were to become unprofitable due to
competition, age of improvements, decreased demand, regulatory changes or other
factors. The conversion of commercial properties to alternate uses often
requires substantial capital expenditures, which may or may not be available.
The availability of credit for commercial mortgage loans may be dependent upon
economic conditions in the markets where such properties are located, as well as
the willingness and ability of lenders to make such loans. The availability of
funds in the credit markets fluctuates and there can be no assurance that the
availability of such funds will increase above, or will not contract below
current levels. In addition, the availability of similar commercial properties,
and the competition for available credit, may affect the ability of potential
purchasers to obtain financing for the acquisition of properties. This could
effect the repayment of commercial mortgages.
Credit-sensitive residential mortgage assets differ from commercial mortgage
assets in several important ways yet can still carry substantial credit risk.
Residential mortgage securities typically are secured by smaller loans to more
obligors than CMBS, thus spreading the risk of mortgagor default. However, most
of the mortgages supporting credit-sensitive residential securities are made to
homeowners that do not qualify for Agency loan programs for reasons including
loan size, financial condition, or work or credit history that may be indicative
of higher risk of default than loans qualifying for such programs. As with
commercial mortgages, in instances of default the Company may incur losses if
proceeds from sales of the underlying residential collateral are less than the
unpaid principal balances of the residential mortgage loans and related
foreclosure costs. However, with residential mortgages this risk may be
mitigated by various forms of credit enhancements including, but not limited to,
primary mortgage insurance.
Through the process of securitizing both commercial and residential mortgages,
credit risk can be heightened or minimized. Senior classes in multi-class
securitizations generally have first priority over cash flows from a pool of
mortgages and, as a result, carry the least risk, highest investment ratings and
the lowest yields. Typically, a securitization will also have mezzanine classes
and subordinated classes. Mezzanine classes will generally have lower credit
ratings, higher yields and may have average lives that are longer than the
senior classes. Subordinate classes are junior in the right to receive cash flow
from the underlying mortgages, thus providing credit enhancement to the senior
and mezzanine classes. As a result, subordinated securities will have even lower
credit ratings and higher yields because of the elevated risk of credit loss
inherent in these securities.
The availability of capital from external sources to finance investments in
credit-sensitive commercial and residential mortgage assets may be diminished
during periods of mortgage finance market illiquidity. Additionally, if market
conditions deteriorate resulting in substantial declines in value of these
assets, sufficient capital may not be available to support the continued
ownership of such investments, requiring these assets to be sold at a loss.
-26-
RISKS ASSOCIATED WITH OWNING REAL ESTATE
The direct ownership of commercial real estate involves a number of risks. With
its first acquisition of real estate, Capstead has attempted to mitigate these
risks by entering into a long-term "net-lease" arrangement whereby the lessee is
responsible for the ongoing operation and management of the properties and for
paying all expenses associated with the operation of the properties. Although
reduced by this net-lease arrangement, risks of ownership remain, including:
o The risk that changes in economic conditions or real estate markets may
adversely affect the value of the properties.
o During inflationary periods, which are generally accompanied by rising
interest rates, increases in operating costs and borrowing rates may be
greater than increases in lessee revenues from operating properties. Over
an extended period of time, this could result in lessee defaults.
o The risk that a deterioration of local conditions could adversely affect
the ability of a lessee to profitably operate a property. For instance, an
oversupply of senior living properties could hamper the leasing of senior
living units at favorable rates. This could ultimately affect the value of
the properties.
o Changes in tax, zoning or other laws could make properties less attractive
or less profitable.
o An owner cannot be assured that lessees will elect to renew their leases
when the terms expire. If a lessee does not renew its lease or otherwise
defaults on its lease obligations, there is no assurance the owner can
obtain a substitute lessee on acceptable terms. If the owner cannot obtain
another qualified operator to lease a property, the owner may be required
to modify the property for a different use, which may involve significant
capital expenditures and delays in re-leasing the property.
o The risk that lessees will not perform under their leases, reducing the
owner's income from the leases or requiring the owner to assume costs (such
as real estate taxes, insurance, utilities and maintenance) that are the
lessees' responsibility under net-leases. In the case of special-purpose
real estate such as senior living facilities, compliance with licensing
requirements could complicate or delay the transfer of operational control
of such properties. This could lead to a significant cash flow burden for
the owner to service the debt and otherwise maintain the properties.
o Net-leases generally require the lessee to carry comprehensive liability,
casualty, workers' compensation and rental loss insurance. The required
coverage is typical of the type, and amount, customarily obtained by an
owner of similar properties. However, there are some types of losses, such
as catastrophic acts of nature, for which insurance cannot be obtained at a
commercially reasonable cost. If there is an uninsured loss or a loss in
excess of insurance limits, the owner could lose both the revenues
generated by the affected property and the capital invested in the
property. The owner would, however, remain obligated to repay any mortgage
indebtedness or other obligations related to the property.
o Investments in real estate are subject to various federal, state and local
regulatory requirements including the Americans with Disabilities Act (the
"ADA"). The ADA requires that public accommodations reasonably accommodate
individuals with disabilities and that new construction or alterations be
made to commercial facilities to conform to accessibility guidelines.
Failure to comply with the ADA can result in injunctions, fines, and damage
awards to private parties and additional capital expenditures to remedy
noncompliance. Existing requirements may change and compliance
-27-
with future requirements may involve significant unanticipated
expenditures. Although typically these expenditures would be the
responsibility of the lessee under the terms of net-leases, if lessees fail
to perform these obligations, the owner may be required to do so.
o Under federal, state and local environmental laws, the owner may be
required to investigate and clean up any release of hazardous or toxic
substances or petroleum products at its properties, regardless of its
knowledge or actual responsibility, simply because of current or past
ownership of the real estate. If unidentified environmental problems arise,
the owner may have to make substantial payments, which could adversely
affect cash flow and the ability to make distributions to stockholders.
This is so because:
1. The owner may have to pay for property damage and for investigation and
clean-up costs incurred in connection with the contamination.
2. The law may impose clean-up responsibility and liability regardless of
whether the owner or operator knew of or caused the contamination. Even
if more than one person is responsible for the contamination, each
person who shares legal liability under environmental laws may be held
responsible for all of the clean-up costs.
3. Governmental entities and third parties may sue the owner or operator
of a contaminated site for damages and costs.
In investigating the acquisition of real estate, environmental studies are
typically performed to establish the existence of any contamination. In
addition, net-leases generally require lessees to operate properties in
compliance with environmental laws and to indemnify the owner against
environmental liability arising from the operation of such properties.
o An owner may desire to sell a property in the future because of changes in
market conditions or poor lessee performance or to avail itself of other
opportunities. An owner may also be required to sell a property in the
future to meet debt obligations or avoid a default. Unlike investments in
mortgage securities, real estate cannot always be sold quickly, and there
can be no assurance that the properties can be sold at a favorable price or
that a prospective buyer will view existing lease or operating arrangements
favorably. In addition, a property may require restoration or modification
before it is sold.
CRITICAL ACCOUNTING POLICIES 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:
o Amortization of Premiums and Discounts on Financial Assets and
Borrowings -- Premiums and discounts on financial assets and borrowings are
recognized in earnings as adjustments to interest income or interest
expense by the interest method over the estimated lives of the related
assets or
-28-
borrowings. For most of Capstead's financial assets, and for its CMO
borrowings, estimates and judgments related to future levels of mortgage
prepayments are critical to this determination (see "Effects of Interest
Rate Changes").
o Fair Value and Impairment Accounting for Financial Assets -- Most of
Capstead's mortgage securities and similar investments portfolio and a
small portion of its CMO collateral and investments portfolio are
classified as held available-for-sale and recorded at fair value on the
balance sheet with unrealized gains and losses recorded in stockholders'
equity as a component of Accumulated other comprehensive income. As such,
these unrealized gains and losses enter into the calculation of book value
per common share. Generally, gains or losses are recognized in earnings
only if sold; however, if a decline in fair value of an individual asset
below its amortized cost occurs that is determined to be other than
temporary, the difference between amortized cost and fair value would be
included in Other revenue (expense) as an impairment charge. Considerable
judgment is required interpreting market data to develop estimated fair
values, particularly in circumstances of deteriorating credit quality and
market liquidity (see "NOTE 10" to the accompanying consolidated financial
statements for discussion of how Capstead values its financial assets,
"Risks of Interest Rate Changes" and "Risks Associated with
Credit-Sensitive Investments").
o Depreciation and Impairment Accounting for Real Estate held for Lease --
Real estate is carried at cost less accumulated depreciation. Depreciation
is provided using the straight-line method over the estimated useful lives
of buildings, equipment and fixtures. If a significant adverse event or
change in circumstances occurs, management would assess if the values of
the Company's real estate properties have become impaired. If estimated
operating cash flows (undiscounted and without interest charges) of a
property over its remaining useful life are less than its net carrying
value, the difference between net carrying value and fair value would be
included in Other revenue (expense) as an impairment charge. Considerable
judgment is required in determining useful lives of components of real
estate properties and in estimating operating cash flows, particularly
during periods of changing circumstances (see "Risks Associated with Owning
Real Estate").
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.
-29-
COMPARISON OF OPERATING INCOME AND DILUTED INCOME PER COMMON SHARE
The following table reconciles net income to operating income and compares the
calculation of operating income per common share to diluted net income per share
(in thousands, except per share amounts):
QUARTER ENDED
---------------------------------------------------------------------------
SEPTEMBER 30, 2003 JUNE 30, 2003 SEPTEMBER 30, 2002
---------------------- ---------------------- ----------------------
OPERATING DILUTED OPERATING DILUTED OPERATING DILUTED
--------- -------- --------- -------- --------- --------
Net income $ 14,779 $ 14,779 $ 15,241 $ 15,241 $ 22,751 $ 22,751
Adjustments for:
Depreciation on real estate 927 -- 927 -- 962 --
Gain on asset sales and
CMO redemptions (1,411) -- (1,393) -- (1,901) --
Series B preferred dividends (4,982) -- (4,982) -- (4,990) --
-------- -------- -------- -------- -------- --------
$ 9,313 $ 14,779 $ 9,793 $ 15,241 $ 16,822 $ 22,751
======== ======== ======== ======== ======== ========
Weighted average common
shares outstanding 13,995 13,995 13,978 13,978 13,871 13,871
Net effect of dilutive securities:
Preferred B shares -- 8,987 -- 8,943 -- 5,638
Stock options and other
preferred shares 353 353 349 349 310 310
-------- -------- -------- -------- -------- --------
14,348 23,335 14,327 23,270 14,181 19,819
======== ======== ======== ======== ======== ========
$ 0.65 $ 0.63 $ 0.68 $ 0.65 $ 1.19 $ 1.15
======== ======== ======== ======== ======== ========
NINE MONTHS ENDED
-------------------------------------------------
SEPTEMBER 30, 2003 SEPTEMBER 30, 2002
---------------------- ----------------------
OPERATING DILUTED OPERATING DILUTED
--------- -------- --------- --------
Net income $ 47,563 $ 47,563 $ 75,712 $ 75,712
Adjustments for:
Depreciation on real estate 2,781 -- 1,604 --
Gain on asset sales and
CMO redemptions (4,551) -- (1,901) --
Series B preferred dividends (14,948) -- (14,970) --
-------- -------- -------- --------
$ 30,845 $ 47,563 $ 60,445 $ 75,712
======== ======== ======== ========
Weighted average common
shares outstanding 13,969 13,969 13,850 13,850
Net effect of dilutive securities:
Preferred B shares -- 8,947 -- 5,639
Stock options and other
preferred shares 351 351 320 320
-------- -------- -------- --------
14,320 23,267 14,170 19,809
======== ======== ======== ========
$ 2.15 $ 2.04 $ 4.27 $ 3.82
======== ======== ======== ========
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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 September 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 Chief Financial Officer ("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 September 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 September 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.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits: The following Exhibits are presented herewith:
Exhibit 12 -- Computation of Ratio of Earnings to Combined Fixed Charges
and Preferred Stock Dividends.
Exhibit 31.1 -- Certification pursuant to Section 302(a) of the
Sarbanes-Oxley Act of 2002.
Exhibit 32.1 -- Certification pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
(b) Reports on Form 8-K:
Current Report on Form 8-K dated July 22, 2003 announcing second quarter
2003 financial results and management changes at Capstead.
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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: November 5, 2003 By: /s/ ANDREW F. JACOBS
-----------------------------------
Andrew F. Jacobs
President and Chief Executive Officer
Date: November 5, 2003 By: /s/ PHILLIP A. REINSCH
-----------------------------------
Phillip A. Reinsch
Senior Vice President and
Chief Financial Officer
-32-