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EX-12 - EXHIBIT 12 - CAPSTEAD MORTGAGE CORPex12.htm
EX-32 - EXHIBIT 32 - CAPSTEAD MORTGAGE CORPex32.htm
EX-31.1 - EXHIBIT 31.1 - CAPSTEAD MORTGAGE CORPex31_1.htm
EX-31.2 - EXHIBIT 31.2 - CAPSTEAD MORTGAGE CORPex31_2.htm

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549
 
FORM 10-Q
 
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended:  June 30, 2015
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:  001-08896
 
CAPSTEAD MORTGAGE CORPORATION
(Exact name of Registrant as specified in its Charter)

Maryland
 
75-2027937
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification No.)

8401 North Central Expressway, Suite 800, Dallas, TX
75225-4404
(Address of principal executive offices)
(Zip Code)
 
(214) 874-2323
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all 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 ☑ NO ☐

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). YES ☑ NO ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer  ☑
Accelerated filer ☐
Non-accelerated filer ☐
Smaller reporting company ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  YES ☐    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 latest practicable date.
 
Common Stock ($0.01 par value)
95,824,551 as of August 7, 2015
 
 


CAPSTEAD MORTGAGE CORPORATION
FORM 10-Q
FOR THE QUARTER ENDED JUNE 30, 2015

INDEX
 
PART I. ¾ FINANCIAL INFORMATION
 
   
Page
ITEM 1.
Financial Statements (unaudited)
 
     
3
     
4
     
5
     
6
     
7
     
ITEM 2.
21
     
ITEM 3.
46
     
ITEM 4.
46
     
 
PART II. ¾ OTHER INFORMATION
 
     
ITEM 6.
47
     
 
49
Computation of Ratio of Income from Continuing Operations
 
Certification Pursuant to Section 302(a)
 
Certification Pursuant to Section 302(a)
 
Certification Pursuant to Section 906
 
 
-2-

ITEM 1.       FINANCIAL STATEMENTS

PART I. ¾ FINANCIAL INFORMATION

CAPSTEAD MORTGAGE CORPORATION
CONSOLIDATED BALANCE SHEETS
(in thousands, except pledged and per share amounts)

   
June 30, 2015
   
December 31, 2014
 
   
(unaudited)
     
Assets
       
Residential mortgage investments ($13.63 and $13.48 billion pledged under repurchase arrangements at June 30, 2015 and December 31, 2014, respectively)
 
$
14,155,863
   
$
13,908,104
 
Cash collateral receivable from interest rate swap counterparties
   
53,326
     
53,139
 
Interest rate swap agreements at fair value
   
318
     
1,657
 
Cash and cash equivalents
   
198,600
     
307,526
 
Receivables and other assets
   
133,178
     
118,643
 
   
$
14,541,285
   
$
14,389,069
 
Liabilities
               
Repurchase arrangements and similar borrowings
 
$
12,967,616
   
$
12,806,843
 
Interest rate swap agreements at fair value
   
27,401
     
27,034
 
Unsecured borrowings
   
100,000
     
100,000
 
Common stock dividend payable
   
30,706
     
34,054
 
Accounts payable and accrued expenses
   
35,014
     
30,367
 
     
13,160,737
     
12,998,298
 
Stockholders’ equity
               
Preferred stock - $0.10 par value; 100,000 shares authorized: 7.50% Cumulative Redeemable Preferred Stock, Series E, 8,086 and 7,618 shares issued and outstanding ($202,146 and $190,454 aggregate liquidation preferences) at June 30, 2015 and December 31, 2014, respectively
   
195,466
     
183,936
 
Common stock - $0.01 par value; 250,000 shares authorized: 95,790 and 95,848 shares issued and outstanding at June 30, 2015 and December 31, 2014, respectively
   
958
     
958
 
Paid-in capital
   
1,317,486
     
1,325,340
 
Accumulated deficit
   
(346,464
)
   
(346,885
)
Accumulated other comprehensive income
   
213,102
     
227,422
 
     
1,380,548
     
1,390,771
 
   
$
14,541,285
   
$
14,389,069
 

See accompanying notes to consolidated financial statements.
 
-3-

CAPSTEAD MORTGAGE CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except per share amounts)
(unaudited)

   
Quarter Ended
June 30
   
Six Months Ended
June 30
 
   
2015
   
2014
   
2015
   
2014
 
Interest income
               
Residential mortgage investments
 
$
50,341
   
$
57,092
   
$
108,986
   
$
116,537
 
Other
   
99
     
77
     
193
     
138
 
     
50,440
     
57,169
     
109,179
     
116,675
 
Interest expense
                               
Repurchase arrangements and similar borrowings
   
(20,098
)
   
(15,542
)
   
(39,312
)
   
(30,949
)
Unsecured borrowings
   
(2,122
)
   
(2,122
)
   
(4,245
)
   
(4,244
)
     
(22,220
)
   
(17,664
)
   
(43,557
)
   
(35,193
)
     
28,220
     
39,505
     
65,622
     
81,482
 
Other revenue (expense)
                               
Salaries and benefits
   
(1,103
)
   
(985
)
   
(2,152
)
   
(2,117
)
Short-term incentive compensation
   
(830
)
   
(397
)
   
(1,522
)
   
(937
)
Long-term incentive compensation
   
(227
)
   
(624
)
   
(835
)
   
(1,250
)
Other general and administrative expense
   
(1,170
)
   
(967
)
   
(2,319
)
   
(2,170
)
Miscellaneous other revenue (expense)
   
54
     
32
     
107
     
(53
)
     
(3,276
)
   
(2,941
)
   
(6,721
)
   
(6,527
)
Net income
 
$
24,944
   
$
36,564
   
$
58,901
   
$
74,955
 
Net income available to common stockholders
                               
Net income
 
$
24,944
   
$
36,564
   
$
58,901
   
$
74,955
 
Less preferred stock dividends
   
(3,788
)
   
(3,449
)
   
(7,530
)
   
(6,687
)
   
$
21,156
   
$
33,115
   
$
51,371
   
$
68,268
 
                                 
Net income per common share
                               
Basic
 
$
0.22
   
$
0.35
   
$
0.54
   
$
0.72
 
Diluted
   
0.22
     
0.35
     
0.54
     
0.71
 
                                 
Weighted average common shares outstanding
                               
Basic
   
95,501
     
95,399
     
95,485
     
95,374
 
Diluted
   
95,689
     
95,626
     
95,682
     
95,583
 
                                 
Cash dividends declared per share
                               
Common
 
$
0.31
   
$
0.34
   
$
0.62
   
$
0.68
 
Series E Preferred
   
0.47
     
0.47
     
0.94
     
0.94
 

See accompanying notes to consolidated financial statements.
 
-4-

CAPSTEAD MORTGAGE CORPORATION
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(in thousands, unaudited)

   
Quarter Ended
June 30
   
Six Months Ended
June 30
 
   
2015
   
2014
   
2015
   
2014
 
Net income
 
$
24,944
   
$
36,564
   
$
58,901
   
$
74,955
 
                                 
Other comprehensive income (loss)
                               
Amounts related to available-for-sale securities:
                               
Change in net unrealized gains
   
(18,747)
   
16,492
     
(12,640)
 
   
33,185
 
Amounts related to cash flow hedges:
                               
Change in net unrealized losses
   
3,400
     
(12,998)
 
   
(14,991)
 
   
(25,654)
 
Reclassification adjustment for amounts included in net income
   
6,863
     
5,384
     
13,311
     
10,106
 
     
(8,484)
 
   
8,878
     
(14,320)
 
   
17,637
 
Comprehensive income
 
$
16,460
   
$
45,442
   
$
44,581
   
$
92,592
 

See accompanying notes to consolidated financial statements.
 
-5-

CAPSTEAD MORTGAGE CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands, unaudited)

   
Six Months Ended June 30
 
   
2015
   
2014
 
Operating activities
       
Net income
 
$
58,901
   
$
74,955
 
Noncash items:
               
Amortization of investment premiums
   
58,135
     
47,429
 
Amortization of equity-based awards
   
1,066
     
1,373
 
Other depreciation and amortization
   
66
     
70
 
Change in measureable hedge ineffectiveness related to interest rate swap agreements designated as cash flow hedges
   
26
     
55
 
Net change in receivables, other assets, accounts payable and accrued expenses
   
7,497
     
2,018
 
Net cash provided by operating activities
   
125,691
     
125,900
 
Investing activities
               
Purchases of residential mortgage investments
   
(1,936,354
)
   
(1,552,525
)
Interest receivable acquired with the purchase of residential mortgage investments
   
(3,027
)
   
(2,449
)
Principal collections on residential mortgage investments, including changes in mortgage securities principal remittance receivable
   
1,603,206
     
1,288,207
 
Net cash used in investing activities
   
(336,175
)
   
(266,767
)
Financing activities
               
Proceeds from repurchase arrangements and similar borrowings
   
58,392,825
     
67,456,237
 
Principal payments on repurchase arrangements and similar borrowings
   
(58,232,051
)
   
(67,152,277
)
Increase in cash collateral receivable from interest rate swap counterparties
   
(187
)
   
(20,089
)
Proceeds from issuance of preferred shares
   
11,531
     
13,838
 
Other capital stock transactions
   
(429
)
   
(512
)
Dividends paid
   
(70,131
)
   
(68,786
)
Net cash provided by financing activities
   
101,558
     
228,411
 
Net change in cash and cash equivalents
   
(108,926
)
   
87,544
 
Cash and cash equivalents at beginning of period
   
307,526
     
413,356
 
Cash and cash equivalents at end of period
 
$
198,600
   
$
500,900
 

See accompanying notes to consolidated financial statements.
-6-

CAPSTEAD MORTGAGE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2015
(unaudited)

NOTE 1 ¾ BUSINESS
 
Capstead Mortgage Corporation operates as a self-managed real estate investment trust for federal income tax purposes (a “REIT”) and is based in Dallas, Texas.  Unless the context otherwise indicates, Capstead Mortgage Corporation, together with its subsidiaries, is referred to as “Capstead” or the “Company.”  Capstead earns income from investing in a leveraged portfolio of residential mortgage pass-through securities consisting almost exclusively of adjustable-rate mortgage (“ARM”) securities issued and guaranteed by government-sponsored enterprises, either Fannie Mae, Freddie Mac, or by an agency of the federal government, Ginnie Mae.  Residential mortgage pass-through securities guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae are referred to as “Agency Securities” and are considered to have limited, if any, credit risk.
 
NOTE 2 ¾ BASIS OF PRESENTATION
 
Interim Financial Reporting and Reclassifications
 
The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X.  Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements.  In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included.  Operating results for the quarter and six months ended June 30, 2015 are not necessarily indicative of the results that may be expected for the calendar year ending December 31, 2015.  For further information refer to the audited consolidated financial statements and footnotes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2014.
 
Recent Accounting Pronouncements
 
In June 2014 the Financial Accounting Standards Board issued Accounting Standards Update (“ASU”) 2014-11, Transfers and Servicing: Repurchase-to-Maturity Transactions, Repurchase Financings and Disclosures (“ASU 2014-11”).  ASU 2014-11 requires repurchase-to-maturity transactions to be accounted for as financings and eliminates existing guidance regarding so-called “linked transactions” between a buyer of securities and a seller that also provides related repurchase financings.  ASU 2014-11 also introduces new disclosure requirements and is effective for periods beginning after December 15, 2014.  The Company adopted ASU 2014-11 on January 1, 2015.  As the Company has not entered into any repurchase-to-maturity or linked transactions, the provisions of this ASU had no effect on the Company’s results of operations, financial condition, or cash flows.
 
NOTE 3 ¾ NET INCOME PER COMMON SHARE
 
Basic net income per common share is computed by dividing net income, after deducting dividends paid or accrued on preferred stock and allocating earnings to equity awards deemed to be participating securities pursuant to the two-class method, by the weighted average number of shares of common stock outstanding, calculated excluding unvested stock awards.  Participating securities include any unvested equity awards that contain non-forfeitable rights to dividends prior to vesting.
 
-7-

Diluted net income per common share is computed by dividing the numerator used to compute basic net income per common share by the denominator used to compute basic net income per common share, further adjusted for the dilutive effect, if any, of equity awards and shares of preferred stock when and if convertible into shares of common stock.  Shares of the Company’s 7.50% Series E Cumulative Redeemable Preferred Stock are contingently convertible into shares of common stock only upon the occurrence of a change in control and therefore are not considered dilutive securities absent such an occurrence.  Any unvested equity awards that are deemed participating securities are included in the calculation of diluted net income per common share, if dilutive, under either the two-class method or the treasury stock method, depending upon which method produces the more dilutive result.

Components of the computation of basic and diluted net income per common share were as follows for the indicated periods (dollars in thousands, except per share amounts):

   
Quarter Ended
June 30
   
Six Months Ended
June 30
 
   
2015
   
2014
   
2015
   
2014
 
Basic net income per common share
               
Numerator for basic net income per common share:
               
Net income
 
$
24,944
   
$
36,564
   
$
58,901
   
$
74,955
 
Preferred stock dividends
   
(3,788
)
   
(3,449
)
   
(7,530
)
   
(6,687
)
Earnings participation of unvested equity awards
   
(33
)
   
(12
)
   
(67
)
   
(36
)
   
$
21,123
   
$
33,103
   
$
51,304
   
$
68,232
 
Denominator for basic net income per common share:
                               
Weighted average common stock outstanding
   
95,805
     
95,767
     
95,815
     
95,772
 
Average unvested stock awards outstanding
   
(304
)
   
(368
)
   
(330
)
   
(398
)
     
95,501
     
95,399
     
95,485
     
95,374
 
   
$
0.22
   
$
0.35
   
$
0.54
   
$
0.72
 
Diluted net income per common share
                               
Numerator for diluted net income per common share:
                               
Numerator for basic net income per common share
 
$
21,123
   
$
33,103
   
$
51,304
   
$
68,232
 
                                 
Denominator for diluted net income per common share:
                               
Denominator for basic net income per common share
   
95,501
     
95,399
     
95,485
     
95,374
 
Net effect of dilutive equity awards
   
188
     
227
     
197
     
209
 
     
95,689
     
95,626
     
95,682
     
95,583
 
   
$
0.22
   
$
0.35
   
$
0.54
   
$
0.71
 
 
-8-

NOTE 4 ¾ RESIDENTIAL MORTGAGE INVESTMENTS
 
Residential mortgage investments classified by collateral type and interest rate characteristics as of the indicated dates were as follows (dollars in thousands):
 
   
Unpaid
Principal
Balance
   
Investment
Premiums
   
Amortized
Cost Basis
   
Carrying
Amount (a)
   
Net
WAC (b)
   
Average
Yield (b)
 
June 30, 2015
                       
Agency Securities:
                       
Fannie Mae/Freddie Mac:
                       
Fixed-rate
 
$
1,148
   
$
3
   
$
1,151
   
$
1,152
     
6.64
%
   
6.20
%
ARMs
   
10,427,265
     
334,633
     
10,761,898
     
10,986,682
     
2.52
     
1.58
 
Ginnie Mae ARMs
   
3,040,934
     
105,777
     
3,146,711
     
3,162,017
     
2.58
     
1.01
 
     
13,469,347
     
440,413
     
13,909,760
     
14,149,851
     
2.53
     
1.45
 
Residential mortgage loans:
                                               
Fixed-rate
   
1,231
     
1
     
1,232
     
1,232
     
6.78
     
4.64
 
ARMs
   
2,810
     
11
     
2,821
     
2,821
     
3.73
     
3.19
 
     
4,041
     
12
     
4,053
     
4,053
     
4.66
     
3.67
 
Collateral for structured financings
   
1,927
     
32
     
1,959
     
1,959
     
8.11
     
7.79
 
   
$
13,475,315
   
$
440,457
   
$
13,915,772
   
$
14,155,863
     
2.53
     
1.46
 
December 31, 2014
                                               
Agency Securities:
                                               
Fannie Mae/Freddie Mac:
                                               
Fixed-rate
 
$
1,660
   
$
4
   
$
1,664
   
$
1,665
     
6.63
     
6.52
 
ARMs
   
10,230,419
     
328,781
     
10,559,200
     
10,800,332
     
2.51
     
1.68
 
Ginnie Mae ARMs
   
2,983,659
     
103,911
     
3,087,570
     
3,099,168
     
2.63
     
1.58
 
     
13,215,738
     
432,696
     
13,648,434
     
13,901,165
     
2.54
     
1.66
 
Residential mortgage loans:
                                               
Fixed-rate
   
1,848
     
2
     
1,850
     
1,850
     
6.96
     
5.65
 
ARMs
   
3,046
     
13
     
3,059
     
3,059
     
3.73
     
3.18
 
     
4,894
     
15
     
4,909
     
4,909
     
4.95
     
4.09
 
Collateral for structured financings
   
1,997
     
33
     
2,030
     
2,030
     
8.11
     
7.86
 
   
$
13,222,629
   
$
432,744
   
$
13,655,373
   
$
13,908,104
     
2.54
     
1.66
 
 
(a) Includes unrealized gains and losses for residential mortgage investments classified as available-for-sale (see NOTE 9).
 
(b) Net WAC, or weighted average coupon, is the weighted average interest rate of the mortgage loans underlying the indicated investments net of servicing and other fees as of the indicated balance sheet date.  Net WAC is expressed as a percentage calculated on an annualized basis on the unpaid principal balances of the mortgage loans underlying these investments.  Average yield is presented for the quarter then ended, and is based on the cash component of interest income expressed as a percentage calculated on an annualized basis on average amortized cost basis (the “cash yield”) less the effects of amortizing investment premiums.  Investment premium amortization is determined using the interest method and incorporates actual and anticipated future mortgage prepayments.

Because of federal government support for Fannie Mae and Freddie Mac, Agency Securities are considered to have limited, if any, credit risk.  Residential mortgage loans held by Capstead were originated prior to 1995 when the Company operated a mortgage conduit and the related credit risk is borne by the Company.  Collateral for structured financings consists of private residential mortgage securities that are backed by loans obtained through this mortgage conduit and are pledged to secure repayment of related structured financings.  Credit risk for these securities is borne by the related bondholders.  The maturity of Residential mortgage investments is directly affected by prepayments of principal on the underlying mortgage loans.  Consequently, actual maturities will be significantly shorter than the portfolio’s weighted average contractual maturity of 290 months.
 
-9-

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

Capstead classifies its ARM investments based on average number of months until coupon reset (“months to roll”).  Months to roll is an indicator of asset duration which is a measure of market price sensitivity to interest rate movements.  A shorter duration generally indicates less interest rate risk.  Current-reset ARM investments have months to roll of less than 18 months while longer-to-reset ARM investments have months to roll of 18 months or greater.  As of June 30, 2015, the average months to roll for the Company’s $7.97 billion (amortized cost basis) in current-reset ARM investments was 6.4 months while the average months to roll for the Company’s $5.94 billion (amortized cost basis) in longer-to-reset ARM investments was 41.2 months.
 
NOTE 5 ¾ REPURCHASE ARRANGEMENTS AND SIMILAR BORROWINGS
 
Capstead pledges its Residential mortgage investments as collateral under repurchase arrangements with commercial banks and other financial institutions, referred to as counterparties, the terms and conditions of which are negotiated on a transaction-by-transaction basis when each such borrowing is initiated or renewed.  Repurchase arrangements entered into by the Company involve the sale and a simultaneous agreement to repurchase the transferred assets at a future date and are accounted for as borrowings.  The Company maintains the beneficial interest in the specific securities pledged during the term of each repurchase arrangement and receives the related principal and interest payments.  The amount borrowed is generally equal to the fair value of the securities pledged, as determined by the lending counterparty, less an agreed-upon discount, referred to as a “haircut.”  Interest rates on these borrowings are fixed based on prevailing rates corresponding to the terms of the borrowings, and interest is paid at the termination of the repurchase arrangement at which time the Company may enter into a new repurchase arrangement at prevailing haircuts and rates with the same counterparty or repay that counterparty and negotiate financing with a different counterparty.  None of the Company’s counterparties are obligated to renew or otherwise enter into new repurchase arrangements at the conclusion of existing repurchase arrangements. In response to declines in fair value of pledged securities due to changes in market conditions or the publishing of monthly security paydown factors, lenders typically require the Company to post additional securities as collateral, pay down borrowings or fund cash margin accounts with the counterparties in order to re-establish the agreed-upon collateral requirements.  These actions are referred to as margin calls.  Conversely, in response to increases in fair value of pledged securities, the Company routinely margin calls its lending counterparties in order to have previously pledged collateral returned to the Company.
 
-10-

Repurchase arrangements and similar borrowings (and related pledged collateral, including accrued interest receivable), classified by collateral type and remaining maturities, and related weighted average borrowing rates as of the indicated dates were as follows (dollars in thousands):

Collateral Type
 
Collateral
Carrying
Amount
   
Accrued
Interest
Receivable
   
Borrowings
Outstanding
   
Average
Borrowing
Rates
 
June 30, 2015
               
Borrowings with maturities of 30 days or less:
               
Agency Securities
 
$
10,629,834
   
$
21,600
   
$
10,130,657
     
0.38
%
Borrowings with maturities greater than 30 days:
                               
Agency Securities (31 to 90 days)
   
1,251,712
     
2,802
     
1,185,000
     
0.44
 
Agency Securities (greater than 90 days)
   
1,747,074
     
4,498
     
1,650,000
     
0.71
 
Similar borrowings:
                               
Collateral for structured financings*
   
1,959
     
     
1,959
     
8.11
 
   
$
13,630,579
   
$
28,900
   
$
12,967,616
     
0.43
 
Quarter-end borrowing rates adjusted for effects of related derivative financial instruments (“Derivatives”)  held as cash flow hedges (see NOTE 6)
                           
0.66
 
December 31, 2014
                               
Borrowings with maturities of 30 days or less:
                               
Agency Securities
 
$
10,401,080
   
$
24,045
   
$
9,878,889
     
0.35
 
Borrowings with maturities greater than 30 days:
                               
Agency Securities (31 to 90 days)
   
1,205,570
     
2,248
     
1,150,924
     
0.35
 
Agency Securities (greater than 90 days)
   
1,874,892
     
4,640
     
1,775,000
     
0.56
 
Similar borrowings:
                               
Collateral for structured financings*
   
2,030
     
     
2,030
     
8.11
 
   
$
13,483,572
   
$
30,933
   
$
12,806,843
     
0.38
 
Year-end borrowing rates adjusted for effects of related Derivatives held as cash flow hedges
                           
0.58
 

* The maturity of structured financings is directly affected by prepayments on the related mortgage pass-through securities pledged as collateral.  Additionally, these financings are subject to redemption by the residual bondholders.

Average borrowings outstanding differed from respective quarter-end balances during the indicated periods primarily due to changes in portfolio levels and differences in the timing of portfolio acquisitions relative to portfolio runoff as illustrated below (dollars in thousands):
 
 
Quarter Ended
 
 
June 30, 2015
 
December 31, 2014
 
 
Average
Borrowings
 
Average
Rate
 
Average
Borrowings
 
Average
Rate
 
Average borrowings and rates adjusted for the effects of related Derivatives held as cash flow hedges for the indicated quarters
  $
13,029,887
     
0.62
%
 
$
12,843,636
     
0.56
%
 
-11-

NOTE 6 ¾ USE OF DERIVATIVE FINANCIAL INSTRUMENTS, OFFSETTING DISCLOSURES AND CHANGES IN OTHER COMPREHENSIVE INCOME BY COMPONENT
 
To help mitigate exposure to higher interest rates, Capstead typically uses currently-paying and forward-starting, one-month LIBOR-indexed, pay-fixed, receive-variable, interest rate swap agreements that require interest payments for two-year terms.  These Derivatives are designated as cash flow hedges of the variability of the underlying benchmark interest rate of current and forecasted 30- to 90-day borrowings under repurchase arrangements.  This hedge relationship establishes a relatively stable fixed rate on related borrowings because the variable-rate payments received on the swap agreements offset a significant portion of the interest accruing on the related borrowings, leaving the fixed-rate swap payments as the Company’s effective borrowing rate, subject to certain adjustments.  These adjustments include differences between variable-rate payments received on the swap agreements and related unhedged borrowing rates as well as the effects of measured hedge ineffectiveness.  Additionally, changes in fair value of these Derivatives tend to partially offset opposing changes in fair value of the Company’s residential mortgage investments that can occur in response to changes in market interest rates.

During the quarter and six months ended June 30, 2015 Capstead entered into swap agreements with notional amounts of $700 million and $1.40 billion, respectively.  These swap agreements require fixed-rate interest payments averaging 0.75% and 0.73% for two-year periods commencing on various dates between January 2015 and June 2015.  Also during these periods, $200 million and $1.30 billion notional amount of swaps requiring fixed-rate interest payments averaging 0.43% and 0.49%, respectively, matured.

At June 30, 2015, the Company’s portfolio of financing-related swap positions had the following characteristics (dollars in thousands):

Period of
Contract Expiration
 
Notional
Amount
   
Average Fixed-Rate
Payment Requirement
 
Currently-paying contracts:
       
Third quarter 2015
 
$
400,000
     
0.47
%
Fourth quarter 2015
   
1,200,000
     
0.45
 
First quarter 2016
   
1,700,000
     
0.51
 
Second quarter 2016
   
1,100,000
     
0.47
 
Third quarter 2016
   
700,000
     
0.56
 
Fourth quarter 2016
   
800,000
     
0.66
 
First quarter 2017
   
1,000,000
     
0.72
 
Second quarter 2017
   
900,000
     
0.74
 
(average expiration: 11 months)
 
$
7,800,000
     
0.57
 
Forward-starting contracts expiring in 2035 and 2036 related to unsecured borrowings
 
$
100,000
     
4.09
 

In addition to portfolio financing-related swap positions, in 2010 the Company entered into three forward-starting, three-month LIBOR-indexed, pay-fixed, receive-variable, interest rate swap agreements with notional amounts totaling $100 million and average fixed rates of 4.09% with 20-year payment terms coinciding with the floating-rate terms of the Company’s Unsecured borrowings which begin between October 30, 2015 and September 15, 2016.  These Derivatives are designated as cash flow hedges of the variability of the underlying benchmark interest rate associated with the floating-rate terms of these long-term borrowings (see NOTE 7).
 
-12-

Interest rate swap agreements are measured at fair value on a recurring basis primarily using Level Two Inputs in accordance with ASU 2010-06, Fair Value Measurements and Disclosures (Topic 820).  In determining fair value estimates for these Derivatives, Capstead utilizes the standard methodology of netting the discounted future fixed cash payments and the discounted future variable cash receipts which are based on expected future interest rates derived from observable market interest rate curves.  Related net interest payable at the balance sheet date is recorded separately.  The Company also incorporates both its own nonperformance risk and its counterparties’ nonperformance risk in determining the fair value of these Derivatives.  In considering the effect of nonperformance risk, the Company considered the impact of netting and credit enhancements, such as collateral postings and guarantees, and has concluded that counterparty risk is not significant to the overall valuation of these agreements.
 
The following tables include fair value and other related disclosures regarding all Derivatives held as of and for the indicated periods (in thousands):
 
 
Balance Sheet
Location
June 30
   
December 31
   
2015
   
2014
 
Balance sheet-related
         
Swap agreements in a gain position (an asset) related to:
         
Borrowings under repurchase arrangements
(a)
 
$
318
   
$
1,657
 
Swap agreements in a loss position (a liability) related to:
                 
Borrowings under repurchase arrangements
(a)
   
(9,587
)
   
(6,332
)
Unsecured borrowings
(a)
   
(17,814
)
   
(20,702
)
Related net interest payable
(b)
   
(12,183
)
   
(9,516
)
      
$
(39,266
)
 
$
(34,893
)
 
(a) The fair value of Derivatives with realized and unrealized gains are aggregated and recorded as an asset on the face of the Balance Sheets separately from the fair value of Derivatives with realized and unrealized losses that are recorded as a liability.  The amount of unrealized losses scheduled to be recognized in the Statements of Income over the next twelve months primarily in the form of fixed-rate swap payments in excess of current market rates totaled $14.9 million at June 30, 2015.
 
(b) Included in “Accounts payable and accrued expenses” on the face of the Balance Sheets.

   
Location of
Gain or
(Loss)
Recognized
in
   
Quarter Ended
June 30
   
Six Months Ended
June 30
 
   
Net Income
   
2015
   
2014
   
2015
   
2014
 
Income statement-related
                   
Components of effect on interest expense:
                   
Amount of loss reclassified from Accumulated other comprehensive income related to the effective portion of active positions
     
$
(6,863
)
 
$
(5,384
)
 
$
(13,311
)
 
$
(10,106
)
Amount of gain (loss) recognized (ineffective portion)
       
3
     
(110
)
   
(306
)
   
(168
)
Increase in interest expense and decrease in Net income as a result of the use of Derivatives
   
*
   
$
(6,860
)
 
$
(5,494
)
 
$
(13,617
)
 
$
(10,274
)
Other comprehensive income-related
                                       
Amount of gain (loss) recognized in Other comprehensive income (loss) (effective portion)
         
$
3,400
   
$
(12,998
)
 
$
(14,991
)
 
$
(25,654
)

* Included in “Interest expense:  Repurchase arrangements and similar borrowings” on the face of the Statements of Income.
 
-13-

Capstead’s swap agreements and borrowings under repurchase arrangements are subject to master netting arrangements in the event of default on, or termination of, any one contract.  See NOTE 5 for more information on the Company’s use of repurchase arrangements.  The following tables provide disclosures concerning offsetting of financial liabilities and Derivatives as of the indicated dates (in thousands):

   
Offsetting of Derivative Assets
     
       
 
   
 
   
Gross Amounts Not Offset
in the Balance Sheet (a)
     
   
Gross
Amounts of
Recognized
Assets
   
Gross
Amounts
Offset in
the Balance
Sheet
   
Net Amounts
of Assets
Presented in
the Balance
Sheet
   
Financial
Instruments
   
Cash
Collateral
Received
   
Net
Amount
 
June 30, 2015
                       
Counterparty 4
 
$
   
$
318
   
$
318
   
$
(318
)
 
$
   
$
 
                                                 
December 31, 2014
                                               
Counterparty 2
 
$
   
$
95
   
$
95
   
$
(95
)
 
$
   
$
 
Counterparty 4
   
1,128
     
434
     
1,562
     
(1,562
)
   
     
 
   
$
1,128
   
$
529
   
$
1,657
   
$
(1,657
)
 
$
   
$
 

   
Offsetting of Financial Liabilities and Derivative Liabilities
 
       
   
   
Gross Amounts Not Offset
in the Balance Sheet (c)
     
   
Gross
Amounts of
Recognized
Liabilities (b)
   
Gross
Amounts
Offset in
the Balance
Sheet
   
Net Amounts
of Liabilities
Presented in
the Balance
Sheet (a)
   
Financial
Instruments
   
Cash
Collateral
Pledged
   
Net
Amount
 
June 30, 2015
                   
Derivatives by counterparty:
                   
Counterparty 1
 
$
20,131
   
$
   
$
20,131
   
$
   
$
(20,131
)
 
$
 
Counterparty 2
   
2,938
     
     
2,938
     
     
(2,800
)
   
138
 
Counterparty 4
   
16,197
     
318
     
16,515
     
(318
)
   
(16,197
)
   
 
     
39,266
     
318
     
39,584
     
(318
)
   
(39,128
)
   
138
 
                                               
Repurchase arrangements and similar borrowings
   
12,976,370
     
     
12,976,370
     
(12,976,370
)
   
     
 
   
$
13,015,636
   
$
318
   
$
13,015,954
   
$
(12,976,688
)
 
$
(39,128
)
 
$
138
 
December 31, 2014
                                               
Derivatives by counterparty:
                                               
Counterparty 1
 
$
24,533
   
$
   
$
24,533
   
$
   
$
(24,533
)
 
$
 
Counterparty 2
   
4,042
     
95
     
4,137
     
(95
)
   
(4,042
)
   
 
Counterparty 3
   
736
     
     
736
     
     
(736
)
   
 
Counterparty 4
   
6,710
     
434
     
7,144
     
(1,562
)
   
(5,582
)
   
 
     
36,021
     
529
     
36,550
     
(1,657
)
   
(34,893
)
   
 
                                               
Repurchase arrangements and similar borrowings
   
12,812,947
     
     
12,812,947
     
(12,812,947
)
   
     
 
   
$
12,848,968
   
$
529
   
$
12,849,497
   
$
(12,814,604
)
 
$
(34,893
)
 
$
 

(a) Amounts presented are limited to recognized liabilities and cash collateral received associated with the indicated counterparty sufficient to reduce the related Net Amount to zero in accordance with ASU No. 2011-11, as amended by ASU No. 2013-01.
 
(b) Amounts include accrued interest of $12.2 million and $9.5 million on interest rate swap agreements and $8.8 million and $6.1 million on repurchase arrangements and similar borrowings, included in “Accounts payable and accrued expenses” on the face of the Balance Sheets as of June 30, 2015 and December 31, 2014, respectively.
 
(c) Amounts presented are limited to recognized assets and collateral pledged associated with the indicated counterparty sufficient to reduce the related Net Amount to zero in accordance with ASU No. 2011-11, as amended by ASU No. 2013-01.
 

-14-

Changes in Accumulated other comprehensive income by component for the quarter and six months ended June 30, 2015 were as follows (in thousands):
 
   
Gains and Losses
on Cash Flow
Hedges
   
Unrealized Gains
and Losses on
Available-for-Sale
Securities
   
Total
 
Balance at March 31, 2015
 
$
(37,252
)
 
$
258,838
   
$
221,586
 
Activity for the quarter ended June 30, 2015:
                       
Other comprehensive income (loss) before reclassifications
   
3,400
     
(18,747
)
   
(15,347
)
Amounts reclassified from accumulated other comprehensive income
   
6,863
     
     
6,863
 
Other comprehensive income (loss)
   
10,263
     
(18,747
)
   
(8,484
)
Balance at June 30, 2015
 
$
(26,989
)
 
$
240,091
   
$
213,102
 
 
Balance at December 31, 2014
 
$
(25,309
)
 
$
252,731
   
$
227,422
 
Activity for the six months ended June 30, 2015:
                       
Other comprehensive income (loss) before reclassifications
   
(14,991
)
   
(12,640
)
   
(27,631
)
Amounts reclassified from accumulated other comprehensive income
   
13,311
     
     
13,311
 
Other comprehensive income (loss)
   
(1,680
)
   
(12,640
)
   
(14,320
)
Balance at June 30, 2015
 
$
(26,989
)
 
$
240,091
   
$
213,102
 
 
NOTE 7 ¾ UNSECURED BORROWINGS
 
Unsecured borrowings consist of 30-year junior subordinated notes issued in 2005 and 2006 and maturing in 2035 and 2036.  Included in Receivables and other assets are $2.1 million in remaining issue costs at June 30, 2015 associated with the original issuance of these notes.  Note balances and related weighted average interest rates as of June 30, 2015 and December 31, 2014 (calculated including issue cost amortization) were as follows (dollars in thousands):
 
   
Borrowings
Outstanding
   
Average
Rate *
 
Junior subordinated notes maturing in:
       
October 2035
 
$
35,000
     
8.31
%
December 2035
   
40,000
     
8.46
 
September 2036
   
25,000
     
8.78
 
   
$
100,000
     
8.49
 
 
  * The indicated weighted average rates have been in effect since issuance.  After considering cash flow hedges that coincide with the floating rate terms of these borrowings that begin October 30, and December 15, 2015 for the notes maturing in October and December 2035 and September 15, 2016 for the notes maturing in September 2036, the effective borrowing rate will average 7.56% beginning September 15, 2016 through maturity, subject to certain adjustments for the effects of measured hedge ineffectiveness, if any.
 
The notes maturing in October 2035 are currently redeemable, in whole or in part, without penalty, at the Company’s option.  The notes maturing in December 2035 are redeemable, in whole or in part, without penalty, at the Company’s option anytime on or after December 15, 2015.  The notes maturing in September 2036 are redeemable, in whole or in part, without penalty, at the Company’s option anytime on or after September 15, 2016.
 
-15-

NOTE 8 ¾ CAPITAL TRANSACTIONS
 
During the quarter and six months ended June 30, 2015, Capstead issued an additional 36,000 and 468,000 shares of its 7.50% Series E Cumulative Redeemable Preferred Stock through an at-the-market continuous offering program at average prices of $24.46 and $24.65, net of underwriting fees and other costs, for net proceeds of $879,000 and $11.5 million, respectively.  Amounts raised subsequent to quarter-end under this program have been minimal.
 
NOTE 9 ¾ DISCLOSURES REGARDING FAIR VALUES OF FINANCIAL INSTRUMENTS
 
This note provides fair value-related disclosures as of the indicated balance sheet dates for Capstead’s financial assets and liabilities, most of which are influenced by changes in, and market expectations for changes in, interest rates and market liquidity conditions, as well as other factors beyond the control of management.  All fair values were determined using Level 2 Inputs in accordance with ASU 2010-06, Fair Value Measurements and Disclosures (Topic 820).

Residential mortgage investments, nearly all of which are mortgage securities classified as available-for-sale, are measured at fair value on a recurring basis.  In determining fair value estimates for mortgage securities, the Company considers recent trading activity for similar investments and pricing levels indicated by lenders in connection with designating collateral for repurchase arrangements, provided such pricing levels are considered indicative of actual market clearing transactions.  In determining fair value estimates for longer-term borrowings under repurchase arrangements, the Company considers pricing levels indicated by lenders for entering into new transactions using similar pledged collateral with terms equal to the remaining terms of the longer-term borrowings.  In determining fair value estimates for unsecured borrowings, the Company considers current pricing for financial instruments with similar characteristics.  Excluded from these disclosures are financial instruments for which the Company’s cost basis is deemed to approximate fair value due primarily to the short duration of these instruments, which are valued using primarily Level 1 measurements, including Cash and cash equivalents, cash collateral receivable from, or payable to, interest rate swap counterparties, receivables, payables and borrowings under repurchase arrangements with initial terms of 90 days or less.  See NOTE 6 for information relative to the valuation of interest rate swap agreements.
 
Fair value-related disclosures for financial instruments other than debt securities were as follows as of the indicated dates (in thousands):

   
June 30, 2015
   
December 31, 2014
 
   
Carrying
Amount
   
Fair
Value
   
Carrying
Amount
   
Fair
Value
 
 
Financial assets:
               
Residential mortgage loans
 
$
4,053
   
$
4,100
   
$
4,909
   
$
5,000
 
Interest rate swap agreements
   
318
     
318
     
1,657
     
1,657
 
Financial liabilities:
                               
Repurchase arrangements with initial terms of greater than 90 days
   
2,575,000
     
2,576,100
     
2,128,517
     
2,128,400
 
Unsecured borrowings
   
100,000
     
100,300
     
100,000
     
100,500
 
Interest rate swap agreements
   
27,401
     
27,401
     
27,034
     
27,034
 
 
 
-16-

Fair value-related disclosures for debt securities were as follows as of the indicated dates (in thousands):

   
Amortized
Cost Basis
   
Gross Unrealized
     
       
Gains
   
Losses
   
Fair Value
 
June 30, 2015
               
Agency Securities classified as available-for-sale:
               
Fannie Mae/Freddie Mac
 
$
10,761,923
   
$
226,933
   
$
2,148
   
$
10,986,708
 
Ginnie Mae
   
3,146,711
     
18,716
     
3,410
     
3,162,017
 
Residential mortgage securities classified as held-to-maturity
   
3,084
     
73
     
     
3,157
 
December 31, 2014
                               
Agency Securities classified as available-for-sale:
                               
Fannie Mae/Freddie Mac
   
10,559,231
     
243,351
     
2,218
     
10,800,364
 
Ginnie Mae
   
3,087,570
     
16,755
     
5,157
     
3,099,168
 
Residential mortgage securities classified as held-to-maturity
   
3,663
     
124
     
     
3,787
 

   
June 30, 2015
      
December 31, 2014
 
   
Fair
Value
   
Unrealized
Loss
   
Fair
Value
   
Unrealized
Loss
 
Securities in an unrealized loss position:
               
One year or greater
 
$
518,021
   
$
2,964
   
$
706,839
   
$
5,320
 
Less than one year
   
1,259,485
     
2,594
     
1,095,724
     
2,055
 
   
$
1,777,506
   
$
5,558
   
$
1,802,563
   
$
7,375
 

Capstead’s investment strategy involves managing a leveraged portfolio of relatively short-duration ARM Agency Securities and management expects these securities will be held until payoff absent a major shift in strategy or a severe contraction in the Company’s ability to obtain financing to support its portfolio.  Declines in fair value caused by increases in interest rates are typically modest for investments in short-duration ARM Agency Securities compared to investments in longer-duration ARM or fixed-rate assets.  These declines are generally recoverable in a relatively short period of time as coupon interest rates on the underlying mortgage loans reset to rates more reflective of the then current interest rate environment.

From a credit risk perspective, federal government support for Fannie Mae and Freddie Mac helps ensure that fluctuations in value due to credit risk associated with these securities will be limited.  Given that (a) any existing unrealized losses on mortgage securities held by the Company are not attributable to credit risk and declines in fair value of ARM securities due to changes in interest rates are generally recoverable in a relatively short period of time, (b) the Company typically holds its investments to maturity, and (c) it is more likely than not that the Company will not be required to sell any of its investments given the resiliency of the financing market for Agency Securities, none of these investments are considered other-than-temporarily impaired at June 30, 2015.
 
NOTE 10 ¾ COMPENSATION PROGRAMS
 
The compensation committee of Capstead’s board of directors (the “Committee”) is responsible for establishing, implementing, and monitoring the Company’s compensation program and practices.  In 2013 the Committee replaced an absolute return-based, discretionary bonus program and an absolute return-based stock award program with largely nondiscretionary and formulaic, target-based annual and long-term incentive compensation programs for key executives with multiple, pre-established performance goals and defined threshold, target and maximum awards as a percentage of base salary.
 
-17-

Equity-based awards as well as other incentive awards that recognize the creation of value for stockholders and promote the Company’s long-term growth and success are made pursuant to the Company’s Amended and Restated 2014 Flexible Incentive Plan, approved by stockholders in May 2014.  At June 30, 2015, this plan had 4,432,739 shares of common stock remaining available for future issuances.
 
Short-term Incentive Compensation Programs
 
The Committee periodically reviews Capstead’s annual incentive compensation program, establishing and implementing desired changes in performance metrics, composition of the mortgage REIT industry peer group used for measurement purposes and each participating officer’s targeted award opportunity.  Under the provisions of the program in effect for 2015 and 2014, awards are made based on (a) economic return (change in book value plus dividends) measured on a relative basis, and, to a lesser extent, on an absolute return basis, (b) relative operating cost efficiency (operating expenses divided by Unsecured borrowings and Stockholders’ equity), and (c) each participating officer’s attainment of stated goals and objectives.  Each participating officer has a targeted award opportunity equal to 125% of his base salary.  Under the terms of the program, each performance metric is assigned a weighting and the Company’s performance relative to each metric is calculated separately. No awards can be earned for performance below the defined threshold returns and awards are capped for performance above the defined maximum return levels.  Included in Accounts payable and accrued expenses at June 30, 2015 are annual incentive compensation accruals for all employees totaling $1.1 million.  Recognized in Short-term incentive compensation are $627,000 and $1.1 million related to annual incentive compensation for all employees for the quarter and six months ended June 30, 2015, respectively.

The Committee administers an additional performance-based short-term incentive compensation program for key executives that provides for quarterly cash payments equal to per share dividends declared on Capstead’s common stock multiplied by a notional amount of non-vesting shares of common stock (“Dividend Equivalent Rights” or “DERs”).  DERs only represent the right to receive the same cash distributions that the Company’s common stockholders are entitled to receive during the term of the grants, subject to certain conditions, including continuous service.  In December 2014 the Committee extended the term of the 654,000 outstanding DERs to December 31, 2015. In April 2015 the Compensation Committee issued 90,000 DERs to a new executive and 90,000 DERs were forfeited by a departing executive..  Included in Accounts payable and accrued expenses are second quarter 2015 DERs distribution amounts totaling $203,000 that were paid in July 2015.  Recognized in Short-term incentive compensation are $203,000 and $405,000 related to the DERs program for the quarter and six months ended June 30, 2015, respectively.
 
Long-term Equity-based Awards – Performance-based RSUs
 
The Committee adopted a new performance-based long-term incentive compensation program for key executives in December 2013.  The program provides for the grant of performance-based RSUs that are convertible into common shares following three-year performance periods, contingent upon whether, and to what extent, defined performance levels established for certain relative and absolute return performance metrics are met or exceeded.  The relative return metrics measure the Company’s performance against its peers in the mortgage REIT industry on the basis of relative economic return and relative total stockholder return (change in stock price plus reinvested dividends).  The absolute economic return metric measures performance against defined return levels.  For conversion purposes, each performance metric is assigned a weighting and the Company’s performance relative to each metric is calculated separately.  The actual number of shares of common stock the units can convert into for each of the metrics, if any, can range from one-half of a share per unit if that metric’s minimum threshold of performance is met, to two shares per unit if the related maximum performance threshold is met or exceeded, adjusted for the weighting assigned to the metric.  If a metric’s minimum performance threshold is not met, no shares are issuable under that metric.  Dividends accrue from the date of grant and will be paid in cash when the units convert into shares of common stock based on the number of shares ultimately issued, if any.
 
-18-

Pursuant to this program, in January 2015 and December 2013 the Committee granted 247,512 and 242,505 RSUs with three-year performance periods ending December 31, 2017 and 2016, respectively.  With the April 2015 departure of a participating executive, 37,199 and 36,467 RSUs issued in 2015 and 2013, respectively, were forfeited.  Initial grant date fair values of $8.83 and $12.45 were assigned to each unit of the January 2015 and December 2013 grants, respectively.  In the fourth quarter of 2014 the three-year compensation cost estimate for the December 2013 grant was reduced to $7.21 per unit.  Recognized in Long-term incentive compensation are $143,000 and $471,000 related to the RSUs for the quarter and six months ended June 30, 2015, respectively (net of a $137,000 adjustment related to forfeitures).
 
Long-term Equity-based Awards – Stock Awards
 
Under an absolute return performance-based stock award program terminated in 2013, the Committee granted common stock awards to all employees with staggered three-year vesting periods.  These awards vest if annualized returns in excess of established return levels are generated during three-year measurement periods.  Vesting can be deferred and a new three-year measurement period established to include the subsequent year, up to and including the seventh calendar year after the year of grant.  Any remaining unvested awards issued under this program will expire if the required returns are not generated for the final three-year measurement period.  Grants made under this program totaling 125,221 shares with an average grant date fair value of $12.58 vested in February 2015 pertaining to initial measurement periods ending December 31, 2014.  Remaining grants under this program totaling 118,784 and 62,137 shares with average grant date fair values of $12.17 and $11.67 are scheduled to vest in February 2016 and 2017, respectively, assuming performance criteria and service conditions are met.

In December 2014 and 2013 respectively, the Committee granted service-based stock awards for 37,237 and 35,703 shares of common stock with grant date fair values of $12.47 and $12.34 to employees not awarded RSUs.  These awards vest January 2, 2018 and January 2, 2017, respectively, assuming service conditions are met.  As a component of the Company’s director compensation program, directors are granted stock awards annually upon election or re-election to the board of directors that vest approximately one year from issuance.  In July 2014, director stock awards for 35,000 shares with a grant date fair value of $13.16 were granted that vested on July 15, 2015.

Performance-based and service-based stock award activity for the six months ended June 30, 2015 is summarized below:
 
   
Number of
Shares
   
Weighted Average
Grant Date
Fair Value
 
Unvested stock awards outstanding at December 31, 2014
   
436,581
     
12.29
 
Forfeitures
   
(22,499
)
   
12.00
 
Vestings
   
(125,221
)
   
12.58
 
Unvested stock awards outstanding at June 30, 2015
   
288,861
     
12.19
 

During the quarter and six months ended June 30, 2015, the Company recognized in Long-term incentive compensation $84,000 and $364,000, respectively, related to amortization of the grant date fair value of employee performance-based and service-based stock awards (net of a $172,000 adjustment related to forfeitures).  The amounts amortized for these periods assumed that performance metrics, if applicable, would continue to be met for related initial measurement periods.  In addition, the Company recognized in Other general and administrative expense $116,000 and $231,000 related to amortization of the grant date fair value of service-based director stock awards during the quarter and six months ended June 30, 2015, respectively.
 
-19-

All service-based stock awards receive dividends on a current basis without risk of forfeiture if the related awards do not vest.  Outstanding performance-based stock awards defer the payment of dividends accruing between the grant dates and the end of related performance periods.  If these awards do not vest, the related accrued dividends will be forfeited.
 
Long-term Equity-based Awards – Option Awards
 
Option awards currently outstanding have ten-year contractual terms from the grant date and were issued with strike prices equal to the quoted market prices of Capstead’s common shares on the dates of grant, all of which were prior to 2010.  No option award activity occurred during 2015.  All outstanding option awards are exercisable at June 30, 2015.  These awards totaled 40,000 shares with a weighted average remaining contractual term of 3.0 years and an aggregate intrinsic value of $5,000.  The fair value of these awards was estimated on the dates of grant using a Black-Scholes option pricing model and was expensed over the related vesting periods.
 
Other Benefit Programs
 
Capstead sponsors a qualified defined contribution retirement plan for all employees and a nonqualified deferred compensation plan for certain of its executives.  In general the Company matches up to 50% of a participant’s voluntary contribution up to a maximum of 6% of a participant’s base salary and annual incentive compensation payments and makes discretionary contributions of up to another 3% of such compensation regardless of participation in the plans.  Company contributions are subject to certain vesting requirements that have been met by nearly all of Capstead’s current employees.  During the quarter and six months ended June 30, 2015, the Company recognized in Salaries and benefits $87,000 and $162,000 related to contributions to these plans, respectively.
 
-20-

ITEM 2.      MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
 
FINANCIAL CONDITION
 
Overview
 
Capstead operates as a self-managed REIT and earns income from investing in a leveraged portfolio of residential mortgage pass-through securities consisting almost exclusively of short-duration ARM Agency Securities, which are considered to have limited, if any, credit risk and reset to more current interest rates within a relatively short period of time.  See NOTE 1 to the consolidated financial statements (included under Item 1 of this report) for certain defined terms used in this discussion and analysis.  Capstead’s strategy of investing in ARM Agency Securities positions the Company to benefit from potential recoveries in financing spreads that typically contract during periods of rising interest rates and experience smaller fluctuations in portfolio values compared to leveraged portfolios containing a significant amount of longer-duration ARM or fixed-rate mortgage securities.  Duration is a common measure of market price sensitivity to interest rate movements.  A shorter duration generally indicates less interest rate risk.

Capstead has typically financed its residential mortgage investments by borrowing under repurchase arrangements with commercial banks and other financial institutions (referred to as “repo” borrowings) supported by its long-term investment capital.  Subsequent to quarter-end, the Company improved its funding flexibility by gaining membership in the Federal Home Loan Bank (“FHLB”) of Cincinnati through a wholly-owned captive insurance subsidiary.  In August 2015 this subsidiary began receiving advances from the bank in the form of secured borrowings, which are similar to repo borrowings.  At June 30, 2015, long-term investment capital totaled $1.48 billion and consisted of $1.19 billion of common and $195 million of perpetual preferred stockholders’ equity (recorded amounts) and $100 million of unsecured borrowings that mature in 2035 and 2036.  Long-term investment capital decreased by less than one percent ($10 million) during the six months ended June 30, 2015 primarily as a result of lower unrealized portfolio gains, net of lower pricing levels for interest rate swap agreements held for hedging purposes ($14 million), and dividend distributions in excess of earnings ($8 million) partially offset by raising $12 million in new 7.50% Series E preferred capital using an at-the-market continuous offering program.

Capstead’s holdings of residential mortgage investments increased by $248 million during the six months ended June 30, 2015 to $14.16 billion, with portfolio acquisitions exceeding portfolio runoff by $253 million (principal amount).  Repo borrowings increased by $161 million during the six months ended June 30, 2015 to $12.97 billion.  Portfolio leverage (portfolio-related borrowings divided by long-term investment capital) increased to 8.76 to one at June 30, 2015 from 8.59 to one at December 31, 2014.  Management believes borrowing at current levels represents an appropriate and prudent use of leverage for a portfolio consisting of seasoned, short-duration ARM Agency Securities.

Capstead reported net income of $25 million and $59 million or $0.22 and $0.54 per diluted common share for the quarter and six months ended June 30, 2015, respectively, compared to $37 million and $75 million or $0.35 and $0.71 per diluted common share for the same periods in 2014.  The Company declared a second quarter 2015 common dividend of $0.31 per share that was paid July 20, 2015 to holders of record on June 30, 2015.  Financing spreads on residential mortgage investments* averaged 0.84% and 0.97% for the quarter and six months ended June 30, 2015, respectively, compared to 1.22% and 1.26% during the same periods in 2014.  Earnings and financing spreads in 2015 were negatively affected by increased investment premium amortization resulting from higher levels of mortgage prepayments than experienced during the same periods in 2014.

* Financing spreads on residential mortgage investments is a non-GAAP financial measure based solely on yields on residential mortgage investments, net of portfolio-related borrowing rates, adjusted for currently-paying interest rate swap agreements held for hedging purposes.  This measure differs from total financing spreads, an all-inclusive GAAP measure that includes yields on all interest-earning assets, as well as rates paid on all interest-bearing liabilities, principally unsecured borrowings.  See page 28 for a reconciliation of these GAAP and non-GAAP financial measures.
 
-21-

Risk Factors and Critical Accounting Policies
 
Under the captions “Risk Factors” and “Critical Accounting Policies” are discussions of risk factors and critical accounting policies affecting Capstead’s financial condition and earnings that are an integral part of this discussion and analysis.  Readers are strongly urged to consider the potential impact of these factors and accounting policies on the Company and its financial results.
 
Capital Transactions
 
During the quarter and six months ended June 30, 2015, Capstead issued an additional 36,000 and 468,000 shares, respectively, of its 7.50% Series E Cumulative Redeemable Preferred Stock through an at-the-market continuous offering program at average prices of $24.46 and $24.65, net of underwriting fees and other costs, for net proceeds of $1 million and $12 million, respectively.  Amounts raised subsequent to quarter-end under this program have been minimal.  Additional amounts of Series E preferred capital and new common equity capital may be raised in the future under continuous offering programs or by other means, subject to market conditions, compliance with federal securities laws and blackout periods associated with the dissemination of important Company-specific news.

Book Value per Common Share
 
The following table illustrates the progression of Capstead’s book value per common share as well as changes in book value expressed as percentages of beginning book value for the indicated periods:
 
 
   
Quarter Ended
June 30, 2015
   
Six Months Ended
June 30, 2015
 
Book value per common share, beginning of period
 
$
12.47
       
$
12.52
     
Change in unrealized gains and losses on mortgage securities classified as available-for-sale
   
(0.20
)
       
(0.13
)
   
Change in unrealized gains and losses on interest rate swap agreements designated as cash flow hedges of:
                       
Repo borrowings
   
0.01
         
(0.05
)
   
Unsecured borrowings
   
0.10
         
0.03
     
     
(0.09
)
 
(0.7
)%
   
(0.15
)
 
(1.2
)%
Capital transactions:
                           
Dividend distributions in excess of earnings
   
(0.09
)
         
(0.08
)
     
Other (principally related to equity awards)
   
0.01
           
0.01
       
     
(0.08
)
 
(0.7
)%
   
(0.07
)
 
(0.6
)%
Book value per common share, end of period
 
$
12.30
         
$
12.30
       
                             
Decrease in book value per common share during the indicated periods
 
$
(0.17
)
 
(1.4
)%
 
$
(0.22
)
 
(1.8
)%
 
Nearly all of Capstead’s residential mortgage investments and all of its interest rate swap agreements are reflected at fair value on the Company’s balance sheet and are therefore included in the calculation of book value per common share (total stockholders’ equity, less liquidation preferences for outstanding shares of preferred stock, divided by outstanding shares of common stock).  The Company’s borrowings, however, are not reflected at fair value on the balance sheet.  Fair value is impacted by market conditions, including changes in interest rates, and the availability of financing at reasonable rates and leverage levels, among other factors.  The Company’s investment strategy attempts to mitigate these risks by focusing on investments in Agency Securities, which are considered to have little, if any, credit risk and are collateralized by ARM loans with interest rates that reset periodically to more current levels generally within five years.  Because of these characteristics, the fair value of the Company’s portfolio is considerably less vulnerable to significant pricing declines caused by credit concerns or rising interest rates compared to leveraged portfolios containing a significant amount of non-agency securities or longer-duration ARM and/or fixed-rate Agency Securities.
 
-22-

Residential Mortgage Investments
 
Capstead’s investment strategy focuses on managing a large portfolio of residential mortgage investments consisting almost exclusively of ARM Agency Securities.  Agency Securities are considered to have limited, if any, credit risk because the timely payment of principal and interest is guaranteed by Fannie Mae and Freddie Mac, which are federally chartered corporations, or Ginnie Mae, which is an agency of the federal government.  Federal government support for Fannie Mae and Freddie Mac has largely alleviated market concerns regarding the ability of Fannie Mae and Freddie Mac to fulfill their guarantee obligations.

ARM securities are backed by residential mortgage loans that have coupon interest rates that adjust at least annually to more current interest rates or begin doing so after an initial fixed-rate period.  These coupon interest rate adjustments are usually subject to periodic and lifetime limits, or caps, on the amount of such adjustments during any single interest rate adjustment period and over the contractual term of the underlying loans.  After the initial fixed-rate period, if applicable, the coupon interest rates of mortgage loans underlying the Company’s ARM securities typically adjust either:

annually based on specified margins over the one-year Constant Maturity U.S. Treasury Note Rate (“CMT”) or the one-year London interbank offered rate (“LIBOR”),
 
semiannually based on specified margins over six-month LIBOR, or
 
monthly based on specified margins over indices such as one-month LIBOR, the Eleventh District Federal Reserve Bank Cost of Funds Index, or over a rolling twelve month average of the one-year CMT index.

By focusing on investing in short-duration ARM Agency Securities, changes in fair value caused by changes in interest rates are typically relatively modest compared to changes in fair value of investments in longer-duration ARM or fixed-rate assets.  Declines in fair value caused by increases in interest rates are generally recoverable in a relatively short period of time as coupon interest rates on the underlying mortgage loans reset to rates more reflective of the then current interest rate environment.  This investment strategy positions the Company to benefit from potential recoveries in financing spreads that typically contract during periods of rising interest rates.

The following table illustrates the progression of the Capstead’s portfolio of residential mortgage investments for the quarter and six months ended June 30, 2015 (dollars in thousands):

         
   
Quarter
Ended
June 30, 2015
   
Six Months
Ended
June 30, 2015
 
Residential mortgage investments, beginning of period
 
$
14,150,084
   
$
13,908,104
 
Portfolio acquisitions (principal amount) at average lifetime purchased yields of 2.50% and 2.43%, respectively
   
944,467
     
1,870,505
 
Investment premiums on acquisitions*
   
32,339
     
65,849
 
Portfolio runoff (principal amount)
   
(919,223
)
   
(1,617,820
)
Investment premium amortization
   
(33,057
)
   
(58,135
)
Decrease in net unrealized gains on securities classified as available-for-sale
   
(18,747
)
   
(12,640
)
Residential mortgage investments, end of period
 
$
14,155,863
   
$
14,155,863
 
Increase in residential mortgage investments during the indicated periods
 
$
5,779
   
$
247,759
 

* Residential mortgage investments typically are acquired at a premium to the securities’ unpaid principal balances.  Investment premiums are recognized in earnings as portfolio yield adjustments using the interest method over the estimated lives of the related investments.  As such, the level of mortgage prepayments impacts how quickly investment premiums are amortized.
 
-23-

Capstead classifies its ARM securities based on the average length of time until the loans underlying each security reset to more current rates (“months-to-roll”) (less than 18 months for “current-reset” ARM securities, and 18 months or greater for “longer-to-reset” ARM securities).  After consideration of any applicable initial fixed-rate periods, at June 30, 2015 approximately 87%, 8% and 5% of the Company’s ARM securities were backed by mortgage loans that reset annually, semi-annually and monthly, respectively.  Approximately 76% of the Company’s current-reset ARM securities have reached an initial coupon reset date, while none of its longer-to-reset ARM securities have reached an initial coupon reset date.  Additionally, at June 30, 2015 approximately 10% of the Company’s ARM securities were backed by interest-only loans, with remaining interest-only payment periods of up to nine years.  All percentages are based on averages of the characteristics of mortgage loans underlying each security and calculated using unpaid principal balances as of the indicated date.  The Company’s ARM holdings featured the following characteristics at June 30, 2015 (dollars in thousands):

 
 
ARM Type
 
Amortized
Cost Basis (a)
 
Net
WAC (b)
   
Fully
Indexed
WAC (b)
   
Average
Net
Margins (b)
   
Average
Periodic
Caps (b)
   
Average
Lifetime
Caps (b)
   
Months
To
Roll
 
Current-reset ARMs:
                         
Fannie Mae Agency Securities
 
$
4,396,621
   
2.30
%
   
2.33
%
   
1.71
%
   
3.36
%
   
9.78
%
   
5.7
 
Freddie Mac Agency Securities
   
1,744,634
   
2.45
     
2.46
     
1.82
     
2.57
     
9.99
     
6.9
 
Ginnie Mae Agency Securities
   
1,825,067
   
2.41
     
1.78
     
1.51
     
1.06
     
8.42
     
7.6
 
Residential mortgage loans
   
2,821
   
3.39
     
2.38
     
2.04
     
1.59
     
10.98
     
4.8
 
(57% of total)
   
7,969,143
   
2.36
     
2.23
     
1.69
     
2.66
     
9.51
     
6.4
 
Longer-to-reset ARMs:
                                                     
Fannie Mae Agency Securities
   
2,614,313
   
2.73
     
2.45
     
1.66
     
3.95
     
7.75
     
40.5
 
Freddie Mac Agency Securities
   
2,006,330
   
2.77
     
2.49
     
1.70
     
3.21
     
7.85
     
44.0
 
Ginnie Mae Agency Securities
   
1,321,644
   
2.81
     
1.77
     
1.51
     
1.08
     
7.87
     
38.2
 
(43% of total)
   
5,942,287
   
2.76
     
2.31
     
1.64
     
3.06
     
7.81
     
41.2
 
   
$
13,911,430
   
2.53
     
2.27
     
1.67
     
2.83
     
8.79
     
21.2
 
                                                       
Gross WAC (rate paid by borrowers) (c)
   
3.14
                                         
 
(a) Amortized cost basis represents the Company’s investment (unpaid principal balance plus unamortized investment premiums) before unrealized gains and losses.  At June 30, 2015, the ratio of amortized cost basis to unpaid principal balance for the Company’s ARM holdings was 103.27.  This table excludes $4 million in fixed-rate Agency Securities, residential mortgage loans and private residential mortgage pass-through securities held as collateral for structured financings.
 
(b) Net WAC, or weighted average coupon, is the weighted average interest rate of the mortgage loans underlying the indicated investments, net of servicing and other fees as of the indicated date. Net WAC is expressed as a percentage calculated on an annualized basis on the unpaid principal balances of the mortgage loans underlying these investments.  Fully indexed WAC represents the weighted average coupon upon one or more resets using interest rate indexes and net margins as of the indicated date.  Average net margins represent the weighted average levels over the underlying indexes that the portfolio can adjust to upon reset, usually subject to initial, periodic and/or lifetime caps on the amount of such adjustments during any single interest rate adjustment period and over the contractual term of the underlying loans.  ARM securities with initial fixed-rate periods of five years or longer typically have either 200 or 500 basis point initial caps with 200 basis point periodic caps.  Additionally, certain ARM securities held by the Company are subject only to lifetime caps or are not subject to a cap.  For presentation purposes, average periodic caps in the table above reflect initial caps until after an ARM security has reached its initial reset date and lifetime caps, less the current net WAC, for ARM securities subject only to lifetime caps.  At quarter-end, 66% of current-reset ARMs were subject to periodic caps averaging 1.77%; 24% were subject to initial caps averaging 3.11%; 9% were subject to lifetime caps averaging 7.65%; and 1% were not subject to a cap.  All longer-to-reset ARM securities at June 30, 2015 were subject to initial caps.
 
(c) Gross WAC is the weighted average interest rate of the mortgage loans underlying the indicated investments, including servicing and other fees paid by borrowers, as of the indicated balance sheet date.

Portfolio-related Borrowings
 
Capstead has typically financed its residential mortgage investments by borrowing under repurchase arrangements with commercial banks and other financial institutions, referred to as counterparties, the terms and conditions of which are negotiated on a transaction-by-transaction basis when each such repo borrowing is initiated or renewed.  None of the Company’s counterparties are obligated to renew or otherwise enter into new repurchase transactions at the conclusion of existing repurchase transactions. 
 
-24-

Repurchase arrangements entered into by the Company involve the sale and a simultaneous agreement to repurchase the transferred assets at a future date, routinely with terms of 30 to 90 days, and are accounted for as borrowings by the Company.  The Company maintains the beneficial interest in the specific securities pledged during each borrowing’s term and receives the related principal and interest payments.  The amount borrowed is generally equal to the fair value of the securities pledged, as determined by the lending counterparty, less an agreed-upon discount, referred to as a “haircut.”  Haircuts on outstanding repo borrowings averaged 4.5 percent and ranged from 3.0 to 5.0 percent of the fair value of pledged residential mortgage pass-through securities at June 30, 2015, little changed from the prior year.  After considering haircuts and related interest receivable on the collateral, as well as interest payable on these borrowings, the Company had $683 million of capital at risk with its lending counterparties at June 30, 2015.  The Company did not have capital at risk with any single counterparty exceeding 4.5% at June 30, 2015.
 
Repo borrowing rates are fixed based on prevailing rates corresponding to the terms of the borrowings, and interest is paid at the termination of a repurchase arrangement at which time the Company may enter into a new repurchase arrangement at prevailing haircuts and rates with the same counterparty or repay that counterparty and negotiate financing with a different counterparty.  When the fair value of pledged securities declines due to changes in market conditions or the publishing of monthly security pay down factors, lenders typically require the Company to post additional securities as collateral, pay down borrowings or fund cash margin accounts with the counterparties in order to re-establish the agreed-upon collateral requirements, referred to as margin calls.  Conversely, if collateral fair values increase, lenders are required to release collateral back to the Company pursuant to Company-issued margin calls.

As of June 30, 2015 the Company’s repo borrowings totaled $12.97 billion with 26 counterparties at average rates of 0.43%, before the effects of interest rate swap agreements held as cash flow hedges and 0.66% including the effects of these derivatives.  To help mitigate exposure to higher short-term interest rates and to secure longer-term, committed financing, Capstead may enter into longer-maturity repurchase arrangements if available at attractive rates and terms.  To this end, during the six months ended June 30, 2015 the Company entered into $800 million in 18- to 24-month repo borrowings with average initial maturities of 19 months and borrowing rates of 0.78%, bringing total repo borrowings with initial maturities of at least 12 months to $2.58 billion a quarter-end with average remaining maturities of eight months and average borrowing rates of 0.63%.

Subsequent to quarter-end, the Company improved its funding flexibility by gaining membership in the FHLB of Cincinnati through a wholly-owned captive insurance subsidiary.  In August 2015 this subsidiary began receiving advances from the bank in the form of secured borrowings.  Similar to repo borrowings, the terms of FHLB advances are negotiated on a transaction-by-transaction basis and the amount borrowed is generally equal to the fair value of the securities pledged, less a haircut that must be maintained via a margin call mechanism throughout the term of an advance.  Unlike repo borrowings, Capstead pledges collateral to secure the advance rather than transferring ownership to the bank and simultaneously agreeing to repurchase the transferred assets at a future date.  Borrowing rates can be variable or fixed based on prevailing rates corresponding to the terms of each advance.  To obtain advances, the Company’s captive insurance subsidiary is required to maintain an ownership position in the bank equal to a percentage of outstanding advances.

To further reduce exposure to higher short-term interest rates, the Company uses currently-paying and forward-starting, one-month LIBOR-indexed, pay-fixed, receive-variable, interest rate swap agreements that require interest payments for two-year terms.  Variable payments received by the Company under these swap agreements offset a significant portion of the interest accruing on a like amount of the Company’s 30- to 90-day borrowings.  As a result, the Company’s effective borrowing rate for these borrowings consists of fixed-rate payments made on the swap agreements adjusted for differences between variable rate payments received on the swap agreements and related actual borrowing rates, as well as the effects of measured hedge ineffectiveness.  At June 30, 2015 the Company held currently-paying portfolio financing-related swap agreements totaling $7.80 billion notional amount requiring fixed-rate interest payments averaging 0.57% with average contract expirations of 11 months.
 
-25-

After consideration of all portfolio financing-related swap positions entered into as of quarter-end, the Company’s residential mortgage investments and related repo borrowings had estimated durations at June 30, 2015 of 11 and 8 months, respectively, for a net duration gap of approximately 3 months – see pages 32 and 33 under the caption “Interest Rate Risk” for further information about the Company’s sensitivity to changes in market interest rates.  The Company intends to continue to manage interest rate risk associated with holding and financing is residential mortgage investments by utilizing suitable derivative financial instruments such as interest rate swap agreements as well as longer-maturity repo borrowings if available at attractive terms.

Analysis of Quarterly Financing Spreads
 
Components of quarterly financing spreads on residential mortgage investments, a non-GAAP financial measure, and mortgage prepayment rates, were as follows for the indicated periods:

   
2015
   
2014
   
2013
 
     
Q2
     
Q1
     
Q4
     
Q3
     
Q2
     
Q1
     
Q4
     
Q3
 
                                                               
Yields on residential mortgage investments:(a)
                                                               
Cash yields
   
2.41
%
   
2.42
%
   
2.43
%
   
2.44
%
   
2.46
%
   
2.46
%
   
2.48
%
   
2.50
%
Investment premium amortization
   
(0.95
)
   
(0.72
)
   
(0.77
)
   
(0.84
)
   
(0.75
)
   
(0.67
)
   
(0.74
)
   
(1.14
)
Adjusted yields
   
1.46
     
1.70
     
1.66
     
1.60
     
1.71
     
1.79
     
1.74
     
1.36
 
Related borrowing rates:(b)
                                                               
Unhedged portfolio-related borrowing rates
   
0.41
     
0.38
     
0.36
     
0.32
     
0.32
     
0.34
     
0.38
     
0.37
 
Fixed swap rates
   
0.55
     
0.53
     
0.51
     
0.50
     
0.49
     
0.50
     
0.52
     
0.59
 
Adjusted borrowing rates
   
0.62
     
0.59
     
0.56
     
0.51
     
0.49
     
0.49
     
0.49
     
0.49
 
Financing spreads on residential mortgage investments(c)
   
0.84
     
1.11
     
1.10
     
1.09
     
1.22
     
1.30
     
1.25
     
0.87
 
CPR
   
21.98
     
16.66
     
17.58
     
19.18
     
17.22
     
15.16
     
17.14
     
25.49
 

(a) Cash yields are based on the cash component of interest income.  Investment premium amortization is determined using the interest method which incorporates actual and anticipated future mortgage prepayments.  Both are expressed as a percentage calculated on average amortized cost basis for the indicated periods.
 
(b) Unhedged portfolio-related borrowing rates for the periods presented represent average rates on repurchase agreements and similar borrowings, before consideration of related currently-paying interest rate swap agreements.
 
Fixed swap rates represent the average fixed-rate payments made on currently-paying interest rate swap agreements held for portfolio hedging purposes and exclude differences between LIBOR-based variable-rate payments received on these swaps and unhedged portfolio-related borrowing rates, as well as the effects of any hedge ineffectiveness.  These factors equated to 22 basis points on the average currently-paying swap notional amount outstanding for both the first and second quarters of 2015.
 
Adjusted borrowing rates reflect unhedged portfolio-related borrowing rates, fixed swap rates and the above-mentioned factors, calculated on average related borrowings outstanding for the indicated periods.

Cash yields continued a trend of gradual quarterly declines thus far in 2015 in large part due to coupon interest rates on more of the loans underlying the portfolio reset to fully-indexed levels in the current low interest rate environment.  With the underlying indexes (principally one-year LIBOR) beginning to increase in anticipation of Federal Reserve action to increase short-term interest rates, cash yields may have an opportunity to begin trending higher in future quarters.

Portfolio yield adjustments for investment premium amortization are primarily driven by changes in mortgage prepayment rates and investment premium levels.  Mortgage prepayment levels are influenced by the availability of mortgage financing at attractive terms and the health of the housing markets.  Mortgage prepayments increased during the second quarter of 2015 primarily due to lower mortgage rates available earlier in the year as well as seasonal factors, leading to higher investment premium amortization and lower yields.  Mortgage prepayments increased further in July to an annualized CPR of 23.93%, which management anticipates will be the highest monthly rate for the year, given current levels of market interest rates.
 
-26-

Adjusted for portfolio financing-related and currently-paying interest rate swap agreements, portfolio financing-related borrowing rates averaged 0.62% during the second quarter of 2015, an increase of three basis points from the first quarter of 2015 reflecting higher market rates and a greater use of longer-maturity repo borrowings.  Future borrowing rates will be dependent on market conditions, including the availability of longer-maturity borrowings and interest rate swap agreements at attractive rates.

Utilization of Long-term Investment Capital and Potential Liquidity
 
Capstead’s investment strategy involves managing an appropriately leveraged portfolio of ARM Agency Securities that management believes can produce attractive risk-adjusted returns over the long term, while reducing, but not eliminating, sensitivity to changes in interest rates.  Portfolio-related borrowings generally can be increased or decreased on a daily basis to meet cash flow requirements and otherwise manage capital resources efficiently.  Consequently, potential liquidity inherent in the Company’s unencumbered residential mortgage investments is as important as the actual level of cash and cash equivalents carried on the balance sheet.  Potential liquidity is affected by, among other things:
 
· current portfolio leverage levels,
 
· changes in market value of assets pledged and interest rate swap agreements held for hedging purposes as determined by lending and swap counterparties,
 
· principal prepayments,
 
· collateral requirements of lenders and swap counterparties, and
 
· general conditions in the commercial banking and mortgage finance industries.

Future levels of portfolio leverage will be dependent upon many factors, including the size and composition of the Company’s investment portfolio (see “Liquidity and Capital Resources”).

Capstead’s utilization of its long-term investment capital and its estimated potential liquidity were as follows as of June 30, 2015 in comparison with December 31, 2014 (in thousands):

<
   
Investments (a)
   
Portfolio-related
Borrowings
   
Capital
Employed
   
Potential
Liquidity (b)
 
Portfolio
Leverage
Balances as of June 30, 2015:
                     
Residential mortgage investments
 
$
14,155,863
   
$