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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)

 

(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.

 

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.

 

 

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CAPSTEAD MORTGAGE CORPORATION

FORM 10-Q

FOR THE QUARTER ENDED JUNE 30, 2015

INDEX

 

PART I. ¾ FINANCIAL INFORMATION

 

 

PART I. ¾ FINANCIAL INFORMATION

CAPSTEAD MORTGAGE CORPORATION

CONSOLIDATED BALANCE SHEETS

(in thousands, except pledged and per share amounts)

See accompanying notes to consolidated financial statements.

 

CAPSTEAD MORTGAGE CORPORATION

CONSOLIDATED STATEMENTS OF INCOME

(in thousands, except per share amounts)

(unaudited)

See accompanying notes to consolidated financial statements.

 

CAPSTEAD MORTGAGE CORPORATION

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(in thousands, unaudited)

See accompanying notes to consolidated financial statements.

 

CAPSTEAD MORTGAGE CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands, unaudited)

See accompanying notes to consolidated financial statements.

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.

 

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):

 

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):

 

 

(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.

 

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.

 

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):

*	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):

 

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):

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).

 

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.

*

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

 

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):

(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.

 

Changes in Accumulated other comprehensive income by component for the quarter and six months ended June 30, 2015 were as follows (in thousands):

 

 

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):

 

 

*

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.

 

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):

 

 

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

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.

 

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.

 

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:

 

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.

 

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.

 

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.

 

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.

 

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):

*

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.

 

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):

 

(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.