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EX-32 - EXHIBIT 32 - CAPSTEAD MORTGAGE CORPex32.htm
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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:  September 30, 2016
 
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 website, 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)
95,988,971 as of November 4, 2016
 


CAPSTEAD MORTGAGE CORPORATION
FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2016
 
INDEX
 
PART I. ¾ FINANCIAL INFORMATION
 
   
Page
ITEM 1.
Financial Statements (unaudited)
 
     
3
     
4
     
5
     
6
     
7
     
ITEM 2.
21
     
ITEM 3.
47
     
ITEM 4.
47
     
PART II. ¾ OTHER INFORMATION
 
     
ITEM 6.
48
     
 
50
 
-2-

ITEM 1.          FINANCIAL STATEMENTS

PART I. ¾ FINANCIAL INFORMATION

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

   
September 30, 2016
   
December 31, 2015
 
   
(unaudited)
       
Assets
           
Residential mortgage investments ($13.09 and $13.54 billion pledged at September 30, 2016 and December 31, 2015, respectively)
 
$
13,582,323
   
$
14,154,737
 
Cash collateral receivable from interest rate swap counterparties
   
73,191
     
50,193
 
Interest rate swap agreements at fair value
   
2,501
     
7,720
 
Cash and cash equivalents
   
83,697
     
54,185
 
Receivables and other assets
   
164,102
     
179,531
 
   
$
13,905,814
   
$
14,446,366
 
Liabilities
               
Secured borrowings
 
$
12,431,839
   
$
12,958,394
 
Interest rate swap agreements at fair value
   
46,954
     
26,061
 
Unsecured borrowings
   
98,065
     
97,986
 
Common stock dividend payable
   
22,687
     
25,979
 
Accounts payable and accrued expenses
   
36,159
     
39,622
 
     
12,635,704
     
13,148,042
 
Stockholders’ equity
               
Preferred stock - $0.10 par value; 100,000 shares authorized: 7.50% Cumulative Redeemable Preferred Stock, Series E, 8,204 and 8,156 shares issued and outstanding ($205,107  and $203,902 aggregate liquidation preferences) at September 30, 2016 and December 31, 2015, respectively
   
198,331
     
197,172
 
Common stock - $0.01 par value; 250,000 shares authorized: 95,989 and 95,825 shares issued and outstanding at September 30, 2016 and December 31, 2015, respectively
   
960
     
958
 
Paid-in capital
   
1,296,550
     
1,310,563
 
Accumulated deficit
   
(346,464
)
   
(346,464
)
Accumulated other comprehensive income
   
120,733
     
136,095
 
     
1,270,110
     
1,298,324
 
   
$
13,905,814
   
$
14,446,366
 
 
See accompanying notes to consolidated financial statements.
 
-3-

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

   
Quarter Ended
September 30
   
Nine Months Ended
September 30
 
   
2016
   
2015
   
2016
   
2015
 
Interest income:
                       
Residential mortgage investments
 
$
49,845
   
$
49,485
   
$
162,654
   
$
158,471
 
Other
   
174
     
88
     
494
     
281
 
     
50,019
     
49,573
     
163,148
     
158,752
 
Interest expense:
                               
Secured borrowings
   
(26,636
)
   
(22,272
)
   
(80,232
)
   
(61,584
)
Unsecured borrowings
   
(1,970
)
   
(2,122
)
   
(5,923
)
   
(6,367
)
     
(28,606
)
   
(24,394
)
   
(86,155
)
   
(67,951
)
     
21,413
     
25,179
     
76,993
     
90,801
 
Other revenue (expense):
                               
Compensation-related expense
   
(1,299
)
   
(3,064
)
   
(6,565
)
   
(7,573
)
Separation of service charge
   
(2,740
)
   
     
(2,740
)
   
 
Other general and administrative expense
   
(1,239
)
   
(1,309
)
   
(3,565
)
   
(3,628
)
Miscellaneous other revenue
   
305
     
261
     
1,300
     
368
 
     
(4,973
)
   
(4,112
)
   
(11,570
)
   
(10,833
)
Net income
 
$
16,440
   
$
21,067
   
$
65,423
   
$
79,968
 
Net income available to common stockholders:
                               
Net income
 
$
16,440
   
$
21,067
   
$
65,423
   
$
79,968
 
Less preferred stock dividends
   
(3,846
)
   
(3,809
)
   
(11,515
)
   
(11,339
)
   
$
12,594
   
$
17,258
   
$
53,908
   
$
68,629
 
                                 
Net income per common share:
                               
Basic and diluted
 
$
0.13
   
$
0.18
   
$
0.56
   
$
0.72
 
                                 
Weighted average common shares outstanding:
                               
Basic
   
95,678
     
95,530
     
95,647
     
95,500
 
Diluted
   
95,866
     
95,721
     
95,799
     
95,695
 
                                 
Cash dividends declared per share:
                               
Common
 
$
0.23
   
$
0.26
   
$
0.72
   
$
0.88
 
Series E preferred
   
0.47
     
0.47
     
1.41
     
1.41
 

See accompanying notes to consolidated financial statements.
 
-4-

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

   
Quarter Ended
September 30
   
Nine Months Ended
September 30
 
   
2016
   
2015
   
2016
   
2015
 
Net income
 
$
16,440
   
$
21,067
   
$
65,423
   
$
79,968
 
                                 
Other comprehensive income (loss)
                               
Amounts related to available-for-sale securities:
                               
Change in net unrealized gains
   
(19,155
)
   
(11,130
)
   
10,245
     
(23,770
)
Amounts related to cash flow hedges:
                               
Change in net unrealized losses
   
12,558
     
(21,235
)
   
(41,714
)
   
(36,226
)
Reclassification adjustment for amounts included in net income
   
4,927
     
7,183
     
16,107
     
20,494
 
     
(1,670
)
   
(25,182
)
   
(15,362
)
   
(39,502
)
Comprehensive income (loss)
 
$
14,770
   
$
(4,115
)
 
$
50,061
   
$
40,466
 

See accompanying notes to consolidated financial statements.
 
-5-

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

   
Nine Months Ended September 30
 
   
2016
   
2015
 
Operating activities:
           
Net income
 
$
65,423
   
$
79,968
 
Noncash items:
               
Amortization of investment premiums
   
95,139
     
92,458
 
Amortization of equity-based awards
   
1,241
     
1,708
 
Other depreciation and amortization
   
97
     
100
 
Change in measureable hedge ineffectiveness related to interest rate swap agreements designated as cash flow hedges
   
506
     
130
 
Net change in receivables, other assets, accounts payable and accrued expenses
   
(953
)
   
6,389
 
Net cash provided by operating activities
   
161,453
     
180,753
 
Investing activities:
               
Purchases of residential mortgage investments
   
(2,319,819
)
   
(2,757,199
)
Interest receivable acquired with the purchase of residential mortgage investments
   
(3,139
)
   
(4,202
)
Principal collections on residential mortgage investments, including changes in mortgage securities principal remittance receivable
   
2,773,344
     
2,577,985
 
Decrease (increase) in lending counterparty investments
   
50,000
     
(46,002
)
Net cash provided by (used in) investing activities
   
500,386
     
(229,418
)
Financing activities:
               
Proceeds from repurchase arrangements and similar borrowings
   
94,430,910
     
84,927,006
 
Principal payments on repurchase arrangements and similar borrowings
   
(92,332,463
)
   
(87,281,325
)
Proceeds from other secured borrowings
   
1,175,000
     
2,450,000
 
Principal payments on other secured borrowings
   
(3,800,000
)
   
(150,000
)
Increase in cash collateral receivable from interest rate swap counterparties
   
(22,998
)
   
(12,729
)
Proceeds from issuance of preferred shares
   
1,167
     
12,679
 
Other capital stock transactions
   
(57
)
   
(429
)
Dividends paid
   
(83,886
)
   
(103,561
)
Net cash used in financing activities
   
(632,327
)
   
(158,359
)
Net change in cash and cash equivalents
   
29,512
     
(207,024
)
Cash and cash equivalents at beginning of period
   
54,185
     
307,526
 
Cash and cash equivalents at end of period
 
$
83,697
   
$
100,502
 

See accompanying notes to consolidated financial statements.
 
-6-

CAPSTEAD MORTGAGE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2016
(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
 
The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X.  Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements.  In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included.  Operating results for the quarter and nine months ended September 30, 2016 are not necessarily indicative of the results that may be expected for the calendar year ending December 31, 2016.  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, 2015.
 
Recent Accounting Pronouncements
 
In November 2014 the Financial Accounting Standards Board issued ASU 2014-16, Derivatives and Hedging (Topic 815): Determining Whether the Host Contract in a Hybrid Financial Instrument Issued in the Form of a Share is More Akin to Debt or to Equity (“ASU 2014-16”).  ASU 2014-16 provides guidance in evaluating whether the nature of the host contract is more debt-like or equity-like when determining whether derivative financial instruments embedded in the hybrid financial instrument, such as call rights and conversion features, should be bifurcated and accounted for separately.  The Company adopted ASU 2014-16 on January 1, 2016.  The provisions of this ASU had no effect on the Company’s results of operations, financial condition, or cash flows.
 
NOTE 3 ¾ SEPARATION OF SERVICE CHARGE
 
Effective July 14, 2016, Mr. Andrew F. Jacobs resigned as a director of Capstead and from his positions as President and Chief Executive Officer (“CEO”).  Pursuant to an agreement entered into with Mr. Jacobs, he is entitled to payments aggregating $2.3 million in addition to continuing to participate in the Company’s short- and long-term incentive compensation and employee benefit programs through year-end.  Currently estimated costs associated with Mr. Jacobs’ resignation, net of equity award cost accrual reversals, are recorded in Separation of service charge for the quarter ended September 30, 2016.  Currently estimated amounts payable to Mr. Jacobs totaling $2.8 million are included in Accounts payable and accrued expenses.
 
-7-

NOTE 4 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 average number of shares of common stock outstanding, calculated excluding unvested stock awards.  Participating securities include 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):

   
Quarter Ended
September 30
   
Nine Months Ended
September 30
 
   
2016
   
2015
   
2016
   
2015
 
Basic net income per common share
                       
Numerator for basic net income per common share:
                       
Net income
 
$
16,440
   
$
21,067
   
$
65,423
   
$
79,968
 
Preferred stock dividends
   
(3,846
)
   
(3,809
)
   
(11,515
)
   
(11,339
)
Earnings participation of unvested equity awards
   
(40
)
   
(28
)
   
(123
)
   
(95
)
   
$
12,554
   
$
17,230
   
$
53,785
   
$
68,534
 
Denominator for basic net income per common share:
                               
Average number of shares of common stock outstanding
   
95,978
     
95,814
     
95,946
     
95,814
 
Average unvested stock awards outstanding
   
(300
)
   
(284
)
   
(299
)
   
(314
)
     
95,678
     
95,530
     
95,647
     
95,500
 
   
$
0.13
   
$
0.18
   
$
0.56
   
$
0.72
 
Diluted net income per common share
                               
Numerator for diluted net income per common share:
                               
Numerator for basic net income per common share
 
$
12,554
   
$
17,230
   
$
53,785
   
$
68,534
 
                                 
Denominator for diluted net income per common share:
                               
Denominator for basic net income per common share
   
95,678
     
95,530
     
95,647
     
95,500
 
Net effect of dilutive equity awards
   
188
     
191
     
152
     
195
 
     
95,866
     
95,721
     
95,799
     
95,695
 
   
$
0.13
   
$
0.18
   
$
0.56
   
$
0.72
 
 
-8-

NOTE 5 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)
 
September 30, 2016
                                   
Agency Securities:
                                   
Fannie Mae/Freddie Mac:
                                   
Fixed-rate
 
$
416
   
$
1
   
$
417
   
$
417
     
6.68
%
   
6.50
%
ARMs
   
10,030,859
     
319,319
     
10,350,178
     
10,506,371
     
2.69
     
1.56
 
Ginnie Mae ARMs
   
2,964,263
     
98,330
     
3,062,593
     
3,071,174
     
2.55
     
1.16
 
     
12,995,538
     
417,650
     
13,413,188
     
13,577,962
     
2.66
     
1.46
 
Residential mortgage loans:
                                               
Fixed-rate
   
761
     
     
761
     
761
     
6.73
     
4.09
 
ARMs
   
1,904
     
9
     
1,913
     
1,913
     
3.80
     
2.97
 
     
2,665
     
9
     
2,674
     
2,674
     
4.63
     
3.29
 
Collateral for structured financings
   
1,659
     
28
     
1,687
     
1,687
     
8.16
     
7.59
 
   
$
12,999,862
   
$
417,687
   
$
13,417,549
   
$
13,582,323
     
2.66
     
1.46
 
December 31, 2015
                                               
Agency Securities:
                                               
Fannie Mae/Freddie Mac:
                                               
Fixed-rate
 
$
796
   
$
2
   
$
798
   
$
799
     
6.61
%
   
6.17
%
ARMs
   
10,014,401
     
317,545
     
10,331,946
     
10,487,785
     
2.55
     
1.68
 
Ginnie Mae ARMs
   
3,542,541
     
119,225
     
3,661,766
     
3,660,455
     
2.61
     
1.49
 
     
13,557,738
     
436,772
     
13,994,510
     
14,149,039
     
2.57
     
1.63
 
Residential mortgage loans:
                                               
Fixed-rate
   
1,155
     
1
     
1,156
     
1,156
     
6.76
     
5.02
 
ARMs
   
2,650
     
11
     
2,661
     
2,661
     
3.73
     
3.15
 
     
3,805
     
12
     
3,817
     
3,817
     
4.65
     
3.71
 
Collateral for structured financings
   
1,850
     
31
     
1,881
     
1,881
     
8.12
     
7.82
 
   
$
13,563,393
   
$
436,815
   
$
14,000,208
   
$
14,154,737
     
2.57
     
1.63
 
 
(a)
Includes unrealized gains and losses for residential mortgage investments classified as available-for-sale.
 
(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.

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.  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 288 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 London interbank offered rate (“LIBOR”) or the one-year Constant Maturity U.S. Treasury Note Rate (“CMT”), (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 September 30, 2016, the average months to roll for the Company’s $7.63 billion (amortized cost basis) in current-reset ARM investments was 6.2 months while the average months to roll for the Company’s $5.78 billion (amortized cost basis) in longer-to-reset ARM investments was 42.1 months.
 
NOTE 6 ¾ SECURED BORROWINGS
 
Capstead pledges its Residential mortgage investments as collateral for secured borrowings primarily in the form of repurchase arrangements with commercial banks and other financial institutions.  In August 2015 the Company began supplementing its borrowings under repurchase arrangements with advances from the Federal Home Loan Bank (“FHLB”) of Cincinnati (collectively referred to as “counterparties” or “lending counterparties”).  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 financings.  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.  FHLB advances differ from repurchase arrangements in that Capstead pledges collateral to the bank to secure each such advance rather than transferring ownership of the pledged collateral to the bank and simultaneously agreeing to repurchase the transferred assets at a future date.  On January 12, 2016 the FHLB system regulator finalized rules originally proposed in 2014 that generally preclude captive insurers from remaining members beyond February 19, 2017 with transition rules that require outstanding advances to be repaid upon maturity or by that date.  In response to this action, the Company has reduced outstanding FHLB advances to $250 million as of September 30, 2016 and anticipates migrating remaining balances away from the FHLB in November 2016.  FHLB stock held by the Company in connection with advance activity was reduced by $20.0 million and $50.0 million during the quarter and nine months ended September 30, 2016, respectively, with the remaining $10.0 million held at September 30, 2016 expected to be redeemed by December 31, 2016.

The terms and conditions of secured borrowings are negotiated on a transaction-by-transaction basis when each such borrowing is initiated or renewed.  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 are generally fixed based on prevailing rates corresponding to the terms of the borrowings. Interest may be paid monthly or at the termination of a borrowing at which time the Company may enter into a new borrowing at prevailing haircuts and rates with the same lending counterparty or repay that counterparty and negotiate financing with a different lending counterparty.  None of the Company’s lending counterparties are obligated to renew or otherwise enter into new borrowings at the conclusion of existing borrowings.  In response to declines in fair value of pledged securities due to changes in market conditions or the publishing of monthly security pay-down factors, lending counterparties 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.
 
-10-

Secured 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
 
                         
September 30, 2016
                       
Borrowings under repurchase arrangements with maturities of 30 days or less:
                       
Agency Securities
 
$
11,302,826
   
$
24,045
   
$
10,741,746
     
0.71
%
Borrowings under repurchase arrangements with maturities greater than 30 days:
                               
Agency Securities (31 to 90 days)
   
1,365,926
     
2,881
     
1,299,305
     
0.72
 
Agency Securities (greater than 90 days)
   
160,250
     
1,003
     
139,101
     
0.92
 
Similar borrowings:
                               
Collateral for structured financings
   
1,687
     
     
1,687
     
8.16
 
     
12,830,689
     
27,929
     
12,181,839
         
FHLB advances
   
259,367
     
1,039
     
250,000
     
0.71
 
   
$
13,090,056
   
$
28,968
   
$
12,431,839
     
0.72
 
Quarter-end borrowing rates adjusted for effects of related derivative financial instruments (Derivatives) held as cash flow hedges
                           
0.86
 
December 31, 2015
                               
Borrowings under repurchase arrangements with maturities of 30 days or less:
                               
Agency Securities
 
$
9,080,363
   
$
18,504
   
$
8,585,336
     
0.67
%
Borrowings under repurchase arrangements with maturities greater than 30 days:
                               
Agency Securities (31 to 90 days)
   
423,710
     
861
     
346,177
     
0.63
 
Agency Securities (greater than 90 days)
   
1,073,254
     
2,519
     
1,150,000
     
0.75
 
Similar borrowings:
                               
Collateral for structured financings
   
1,881
     
     
1,881
     
8.12
 
     
10,579,208
     
21,884
     
10,083,394
         
FHLB advances
   
2,956,908
     
11,422
     
2,875,000
     
0.43
 
   
$
13,536,116
   
$
33,306
   
$
12,958,394
     
0.62
 
Year-end borrowing rates adjusted for effects of  related Derivatives held as cash flow hedges
                           
0.85
 
 
-11-

Average secured borrowings outstanding during the indicated periods differed from respective ending balances 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
 
   
September 30, 2016
    December 31, 2015  
   
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 periods
 
$
12,731,035
     
0.84
%
 
$
13,160,703
     
0.73
%
 
NOTE 7 ¾ USE OF DERIVATIVES, OFFSETTING DISCLOSURES AND CHANGES IN OTHER COMPREHENSIVE INCOME BY COMPONENT
 
In addition to entering into longer-maturity secured borrowings when available at attractive rates and terms, Capstead attempts to mitigate exposure to higher interest rates by entering into currently-paying and forward-starting, one-month LIBOR-indexed, pay-fixed, receive-variable, interest rate swap agreements.  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 secured borrowings.  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 designated 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 nine months ended September 30, 2016 Capstead entered into swap agreements with notional amounts of $500 million and $2.95 billion requiring fixed-rate interest payments averaging 0.84% and 0.76% for two and three-year periods commencing on various dates between January and September 2016.  Also during the quarter and nine months ended September 30, 2016, $700 million and $3.50 billion notional amount of swaps requiring fixed-rate interest payments averaging 0.56% and 0.51% matured.  At September 30, 2016, the Company’s portfolio financing-related swap positions had the following characteristics (dollars in thousands):

Period of
Contract Expiration
 
Notional
Amount
   
Average Fixed-Rate
Payment Requirement
 
Fourth quarter 2016 (expired October 1, 2016)
 
$
800,000
     
0.66
%
First quarter 2017
   
1,000,000
     
0.72
 
Second quarter 2017
   
900,000
     
0.74
 
Third quarter 2017
   
400,000
     
0.74
 
Fourth quarter 2017
   
1,500,000
     
0.79
 
First quarter 2018
   
1,700,000
     
0.76
 
Second quarter 2018
   
600,000
     
0.79
 
Third quarter 2018
   
400,000
     
0.88
 
Second quarter 2019
   
450,000
     
0.77
 
Third quarter 2019
   
100,000
     
0.68
 
   
$
7,850,000
         
 
-12-

In 2010 the Company entered into 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.  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.

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.  The 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 fair value.  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.  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
 
September 30
   
December 31
 
 
Location
 
2016
   
2015
 
Balance sheet-related
             
Swap agreements in a gain position (an asset) related to Secured borrowings
(a)
 
$
2,501
   
$
7,720
 
Swap agreements in a loss position (a liability) related to:
                 
Secured borrowings
(a)
   
(5,981
)
   
(1,051
)
Unsecured borrowings
(a)
   
(40,973
)
   
(25,010
)
Related net interest payable
(b)
   
(11,727
)
   
(10,942
)
      
$
(56,180
)
 
$
(29,283
)

(a)
The fair value of Derivatives with unrealized gains are aggregated and recorded as an asset on the face of the Balance Sheets separately from the fair value of Derivatives with unrealized losses that are recorded as a liability.  The amount of net 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 $8.8 million at September 30, 2016.
 
(b)
Included in “Accounts payable and accrued expenses” on the face of the Balance Sheets.

   
Location of
Gain or
(Loss)
         
   
Recognized
in
   
Quarter Ended
September 30
   
Nine Months Ended
September 30
 
   
Net Income
   
2016
   
2015
   
2016
   
2015
 
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
       
$
(4,927
)
 
$
(7,183
)
 
$
(16,107
)
 
$
(20,494
)
Amount of gain (loss) recognized (ineffective portion)
         
(323
)
   
(336
)
   
(1,210
)
   
(642
)
Increase in interest expense and decrease in Net income as a result of the use of Derivatives
   
*
   
$
(5,250
)
 
$
(7,519
)
 
$
(17,317
)
 
$
(21,136
)
Other comprehensive income-related
                                       
Amount of gain (loss) recognized in Other comprehensive income (loss) (effective portion)
         
$
12,558
   
$
(21,235
)
 
$
(41,714
)
 
$
(36,226
)

*
Included in “Interest expense:  Secured 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 6 for more information on the Company’s use of secured borrowings.  The following tables provide disclosures concerning offsetting of financial liabilities and Derivatives as of the indicated dates (in thousands):

 
Offsetting of Derivative Assets
       
       
Gross
   
Net Amounts
   
Gross Amounts Not Offset
       
 
Gross
   
Amounts
   
of Assets
   
in the Balance Sheet (a)
       
 
Amounts of
Recognized
   
Offset in
the Balance
   
Presented in
the Balance
   
Financial
   
Cash
Collateral
   
Net
 
   
Assets
   
Sheet
   
Sheet
   
Instruments
   
Received
   
Amount
 
September 30, 2016
                                   
Counterparty 4
 
$
1,126
   
$
1,375
   
$
2,501
   
$
(2,501
)
 
$
   
$
 
                                                 
December 31, 2015
                                               
Counterparty 2
 
$
   
$
23
   
$
23
   
$
(23
)
 
$
   
$
 
Counterparty 4
   
4,758
     
2,939
     
7,697
     
(7,697
)
   
     
 
   
$
4,758
   
$
2,962
   
$
7,720
   
$
(7,720
)
 
$
   
$
 

 
Offsetting of Financial Liabilities and Derivative Liabilities
 
       
Gross
   
Net Amounts
   
Gross Amounts Not Offset
     
 
Gross
   
Amounts
   
of Liabilities
   
in the Balance Sheet (c)
     
 
Amounts of
Recognized
   
Offset in
the Balance
   
Presented in
the Balance
   
Financial
   
Cash
Collateral
   
Net
 
   
Liabilities (b)
   
Sheet
   
Sheet (a)
   
Instruments
   
Pledged
   
Amount
 
September 30, 2016
                             
Derivatives by counterparty:
                             
Counterparty 1
 
$
42,029
   
$
   
$
42,029
   
$
   
$
(42,029
)
 
$
 
Counterparty 4
   
15,277
     
1,375
     
16,652
     
(2,501
)
   
(14,151
)
   
 
     
57,306
     
1,375
     
58,681
     
(2,501
)
   
(56,180
)
   
 
Borrowings under repurchase arrangements
   
12,186,583
     
     
12,186,583
     
(12,186,583
)
   
     
 
   
$
12,243,889
   
$
1,375
   
$
12,245,264
   
$
(12,189,084
)
 
$
(56,180
)
 
$
 
December 31, 2015
                                               
Derivatives by counterparty:
                                               
Counterparty 1
 
$
26,311
   
$
   
$
26,311
   
$
   
$
(26,311
)
 
$
 
Counterparty 2
   
776
     
23
     
799
     
(23
)
   
(776
)
   
 
Counterparty 4
   
6,954
     
2,939
     
9,893
     
(7,697
)
   
(2,196
)
   
 
     
34,041
     
2,962
     
37,003
     
(7,720
)
   
(29,283
)
   
 
Borrowings under repurchase arrangements
   
10,090,846
     
     
10,090,846
     
(10,090,846
)
   
     
 
   
$
10,124,887
   
$
2,962
   
$
10,127,849
   
$
(10,098,566
)
 
$
(29,283
)
 
$
 

(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 $11.7 million and $10.9 million on interest rate swap agreements and $6.4 million and $9.3 million on borrowings under repurchase arrangements, included in “Accounts payable and accrued expenses” on the face of the Balance Sheets as of September 30, 2016 and December 31, 2015, 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 nine months ended September 30, 2016 were as follows (in thousands):
 
   
Gains and Losses
on Cash Flow
Hedges
   
Unrealized Gains
and Losses on
Available-for-Sale
Securities
   
Total
 
Balance at June 30, 2016
 
$
(61,526
)
 
$
183,929
   
$
122,403
 
Activity for the quarter ended September 30, 2016:
                       
Other comprehensive income (loss) before reclassifications
   
12,558
     
(19,155
)
   
(6,597
)
Amounts reclassified from accumulated other comprehensive income
   
4,927
     
     
4,927
 
Other comprehensive income (loss)
   
17,485
     
(19,155
)
   
(1,670
)
Balance at September 30, 2016
 
$
(44,041
)
 
$
164,774
   
$
120,733
 
Balance at December 31, 2015
 
$
(18,434
)
 
$
154,529
   
$
136,095
 
Activity for the nine months ended September 30, 2016:
                       
Other comprehensive income (loss) before reclassifications
   
(41,714
)
   
10,245
     
(31,469
)
Amounts reclassified from accumulated other comprehensive income
   
16,107
     
     
16,107
 
Other comprehensive income (loss)
   
(25,607
)
   
10,245
     
(15,362
)
Balance at September 30, 2016
 
$
(44,041
)
 
$
164,774
   
$
120,733
 
 
NOTE 8 ¾ UNSECURED BORROWINGS
 
Unsecured borrowings consist of 30-year junior subordinated notes issued in 2005 and 2006 and maturing in 2035 and 2036, for a total face amount of $100 million.  The notes are currently redeemable, in whole or in part, without penalty, at the Company’s option.  In 2015 the Company retrospectively adopted ASU 2015-03, which requires debt issuance costs to be recorded as direct deductions from the carrying amounts of the related liabilities, consistent with debt discounts.  Note balances net of debt issuance costs, and related weighted average interest rates as of the indicated dates (calculated including issuance cost amortization and adjusted for effects of related Derivatives held as cash flow hedges) as of September 30, 2016 and December 31, 2015 were as follows (dollars in thousands):

   
September 30, 2016
   
December 31, 2015
 
   
Borrowings
Outstanding
   
Average
Rate
   
Borrowings
Outstanding
   
Average
Rate
 
Junior subordinated notes maturing in:
                       
October 2035
($35,000 face amount)  
$
34,267
     
7.92
%
 
$
34,234
     
7.91
%
December 2035
($40,000 face amount)    
39,272
     
7.68
     
39,244
     
7.68
 
September 2036
($25,000 face amount)    
24,526
     
7.72
     
24,508
     
8.96
 
   
$
98,065
     
7.77
   
$
97,986
     
8.08
 
 
NOTE 9 ¾ CAPITAL TRANSACTIONS
 
During the nine months ended September 30, 2016, Capstead issued an additional 48,000 shares of its 7.50% Series E Cumulative Redeemable Preferred Stock through an at-the-market continuous offering program at an average price of $24.05, net of underwriting fees and other costs, for net proceeds of $1.2 million.  While no shares were issued under this program during the quarter ended September 30, 2016, a modest amount of shares were issued subsequent to quarter-end through November 4, 2016.
 
-15-

NOTE 10 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.  With the exception of the fair value of lending counterparty investments, all fair values were determined using Level 2 Inputs in accordance with ASU 2010-06, Fair Value Measurements and Disclosures (Topic 820).  Lending counterparty investments are nonmarketable securities classified as assets for which Level 3 Inputs are used to determine fair value.  These assets are considered strategic investments that are carried at cost and periodically valued and evaluated for impairment.  No impairment charges have been recorded relative to these investments and the Company’s cost basis is deemed to approximate fair value.

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 the Company considers recent trading activity for similar investments and pricing levels indicated by lenders in connection with designating collateral for secured borrowings, provided such pricing levels are considered indicative of actual market clearing transactions.  In determining fair value estimates for Secured borrowings with initial terms of greater than 120 days, 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 these borrowings.  The Company currently bases fair value for Unsecured borrowings on discounted cash flows using Company estimates for market yields.  Prior to these borrowings’ initial redemption dates, the Company considered then current pricing for financial instruments with similar characteristics in determining fair value estimates.  Excluded from these disclosures are financial instruments for which 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 secured borrowings with initial terms of 120 days or less.  See NOTE 7 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):

 
September 30, 2016
   
December 31, 2015
 
 
Carrying
Amount
   
Fair
Value
   
Carrying
Amount
   
Fair
Value
 
Financial assets:
                       
Residential mortgage loans
 
$
2,674
   
$
2,700
   
$
3,817
   
$
3,900
 
Lending counterparty investments
   
15,002
     
15,002
     
65,002
     
65,002
 
Portfolio-related interest rate swap agreements
   
2,501
     
2,501
     
7,720
     
7,720
 
Financial liabilities:
                               
Secured borrowings with initial terms of greater than 120 days
   
839,101
     
839,300
     
3,246,177
     
3,245,000
 
Unsecured borrowings
   
98,065
     
59,100
     
97,986
     
77,200
 
Interest rate swap agreements:
                               
Portfolio-related
   
5,981
     
5,981
     
1,051
     
1,051
 
Unsecured borrowings-related
   
40,973
     
40,973
     
25,010
     
25,010
 
 
-16-

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

   
Amortized
   
Gross Unrealized
       
   
Cost Basis
   
Gains
   
Losses
   
Fair Value
 
September 30, 2016
                       
Agency Securities classified as available-for-sale:
                       
Fannie Mae/Freddie Mac
 
$
10,350,186
   
$
157,460
   
$
1,267
   
$
10,506,379
 
Ginnie Mae
   
3,062,593
     
14,795
     
6,214
     
3,071,174
 
Residential mortgage securities classified as held-to-maturity
   
2,096
     
25
     
     
2,121
 
December 31, 2015
                               
Agency Securities classified as available-for-sale:
                               
Fannie Mae/Freddie Mac
   
10,331,965
     
166,794
     
10,954
     
10,487,805
 
Ginnie Mae
   
3,661,766
     
11,705
     
13,016
     
3,660,455
 
Residential mortgage securities classified as held-to-maturity
   
2,660
     
44
     
     
2,704
 

 
September 30, 2016
   
December 31, 2015
 
   
Fair
Value
   
Unrealized
Loss
   
Fair
Value
   
Unrealized
Loss
 
Securities in an unrealized loss position:
                       
One year or greater
 
$
813,179
   
$
4,923
   
$
597,652
   
$
4,259
 
Less than one year
   
1,114,807
     
2,558
     
4,468,844
     
19,711
 
   
$
1,927,986
   
$
7,481
   
$
5,066,496
   
$
23,970
 

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 were considered other-than-temporarily impaired at September 30, 2016.
 
NOTE 11 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 programs and practices.  Incentive compensation programs adopted by the Committee for key executives are largely nondiscretionary, formulaic and target-based utilizing multiple pre-established performance goals (referred to as “metrics”) and defined threshold, target and maximum award amounts determined by reference to established percentages of base salaries.  Prior to granting awards, the Committee reviews the Company’s programs, implementing any desired changes in performance metrics and the composition of mortgage REIT industry peer groups used for relative performance metric measurement purposes, as well as establishing each executive’s targeted award opportunity.  Equity-based awards and other long-term incentive awards are made pursuant to the Company’s Amended and Restated 2014 Flexible Incentive Plan, approved by stockholders in May 2014.  At September 30, 2016, this plan had 3,688,541 shares of common stock remaining available for future issuances.
 
-17-

Short-term Incentive Compensation Programs
 
Under the provisions of Capstead’s annual incentive compensation program, each participating executive has an overall target award opportunity equal to 125% of base salary.  Awards are earned based on (a) relative and absolute economic return (change in book value per share of common stock plus common stock dividends divided by beginning book value per share), (b) relative operating cost efficiency (operating expenses divided by Unsecured borrowings and Stockholders’ equity), and (c) attainment of individual goals and objectives.  Each performance metric is assigned a weighting and performance relative to each metric is calculated separately.  No awards can be earned for performance below defined threshold return levels and awards are capped for performance above defined maximum return levels.  Included in Accounts payable and accrued expenses at September 30, 2016 are annual incentive compensation accruals for participating executives (other than the Company’s former CEO), together with discretionary accruals for all other employees, totaling $1.1 million.  Recognized in Compensation-related expense are $292,000 and $1.1 million related to annual incentive compensation for all employees excluding the former CEO for the quarter and nine months ended September 30, 2016, respectively.  An additional $655,000 was recognized in Compensation-related expense during the quarter ended March 31, 2016 related to the March 2016 finalization of 2015 program results.

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.  Included in Accounts payable and accrued expenses and recognized in Compensation-related expense are third quarter 2016 DERs distribution amounts totaling $100,000 that were paid in October 2016 to executives other than the former CEO.  For the nine months ended September 30, 2016, $420,000 was recognized in Compensation-related expense related to the DERs program.

In February 2016 the Committee modified the relative weightings of the various metrics in the annual incentive compensation program for 2016 primarily to place more emphasis on absolute economic return at adjusted threshold, target and maximum return levels, while decreasing other relative weightings.  Additionally, maximum payout percentage opportunities related to achieving or exceeding individual goals and objectives were increased and the term of outstanding DERs was extended to December 31, 2016.
 
Long-term Equity-based Awards – Performance-based RSUs
 
Capstead’s performance-based long-term incentive compensation program for key executives provides for the grant of performance-based RSUs that are convertible into shares of common stock 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 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 threshold level of performance is met, to two shares per unit if the related maximum level of performance is met or exceeded, adjusted for the weighting assigned to the metric.  If a metric’s threshold performance level 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 February 2016, January 2015 and December 2013 the Committee granted 269,354, 247,512 and 242,505 RSUs with three-year performance periods ending December 31, 2018, 2017 and 2016, respectively.  Initial grant date fair values developed for compensation cost purposes of $8.03, $8.83 and $12.45 were assigned to the units of each grant, respectively.  Due to lowered expectations for attainment of certain performance metrics, the three-year cost estimate associated with the December 2013 grant has been reduced three times since issuance (in June 2016, December 2015 and December 2014), ultimately to $3.81 per unit. With the April 2015 resignation of a participating executive, 37,199 and 36,467 RSUs issued in 2015 and 2013, respectively, were forfeited.  With the July 2016 resignation of the former CEO, 99,527 and 93,058 RSUs issued in 2016 and 2015, respectively, are expected to be forfeited by year-end.  Recognized in Compensation-related expense are $237,000 and $786,000 related to outstanding RSUs for the quarter and nine months ended September 30, 2016, respectively.  Included in Common stock dividends payable at September 30, 2016 are estimated dividends payable pertaining to these awards of $308,000.
 
Long-term Equity-based Awards – Stock Awards
 
Under a performance-based stock award program last utilized in 2012, 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, with certain deferred vesting provisions that extend to include the seventh calendar year after the year of grant.  Program grants for 118,784 shares with an average grant date fair value of $12.17 vested in January 2016 pertaining to the measurement period ending December 31, 2015.  The last shares granted under this program totaling 62,137 shares with a grant date fair value of $11.67 are scheduled to vest in February 2017, assuming performance criteria and service conditions are met.

In February 2016 the Committee granted service-based stock awards for 67,337 shares of common stock with a grant date fair value of $9.32 per share to key executives that are scheduled to vest in February 2019 assuming service conditions are met.  With the July 2016 resignation of the former CEO, stock awards for 24,881 shares are expected to be forfeited by year-end.  In January 2016 and December of 2014 and 2013, respectively, the Committee granted service-based stock awards for 61,272, 37,237 and 35,703 shares of common stock with grant date fair values of $7.87, $12.47 and $12.34 per share to employees not awarded RSUs.  These awards vest in January of 2019, 2018 and 2017, respectively, assuming service conditions are met.

As a component of the Company’s director compensation program, directors are granted common stock awards annually upon election or re-election to the board of directors that vest approximately one year from issuance.  In July 2016, director common stock awards for a total of 35,000 shares granted in July 2015 with a grant date fair value of $11.41 per share vested and new awards, for a total of 41,881 shares, with a grant date fair value of $10.03 per share were granted that will vest on July 15, 2017.

Performance-based and service-based stock award activity for the nine months ended September 30, 2016 is summarized below:
 
   
Number of
Shares
   
Weighted Average
Grant Date
Fair Value
 
Unvested stock awards outstanding at December 31, 2015
   
288,861
   
$
11.98
 
Grants
   
170,490
     
8.97
 
Vestings
   
(153,784
)
   
12.00
 
Unvested stock awards outstanding at September 30, 2016
   
305,567
     
10.29
 
 
-19-

During the quarter and nine months ended September 30, 2016, the Company recognized in Compensation-related expense $189,000 and $630,000, respectively, related to amortization of the grant date fair value of employee stock awards.  The amounts amortized for these periods assumed that any applicable performance metrics would continue to be met for related initial measurement periods.  Included in Common Stock dividends payable at September 30, 2016 are estimated dividends payable pertaining to these awards of $332,000.  In addition, the Company recognized in Other general and administrative expense $104,000 and $304,000 related to amortization of the grant date fair value of director stock awards during the quarter and nine months ended September 30, 2016, respectively.  Unrecognized compensation expense for unvested stock awards for all employees and directors other than the former CEO totaled $1.3 million as of September 30, 2016, to be expensed over a weighted average period of 1.3 years (assumes minimal employee and director attrition and any applicable performance metrics would continue to be met for related initial measurement periods).

Service-based stock awards issued to directors and to employees not awarded RSUs receive dividends on a current basis without risk of forfeiture if the related awards do not vest.  Outstanding performance-based stock awards and stock awards issued to key executives defer the payment of dividends accruing between the grant dates and the end of related performance or service periods.  If these awards do not vest, the related accrued dividends will be forfeited.
 
Long-term Equity-based Awards – Option Awards
 
At September 30, 2016 option awards for 40,000 shares of common stock were outstanding with a weighted average strike price of $11.86.  These awards are currently exercisable, have no aggregate intrinsic value and have a weighted average remaining contractual term of 1.7 years.  No option award activity occurred during the quarter and nine months ended September 30, 2016.  All outstanding option awards were granted prior to 2010, have ten-year contractual terms and were issued with strike prices equal to the closing market price of Capstead’s common stock on the dates of grant.  The fair value of these awards was estimated at that time 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. The Company also 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 nine months ended September 30, 2016, the Company recognized in Compensation-related expense $33,000 and $220,000 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 earning income from investing in a leveraged portfolio of residential mortgage pass-through securities consisting almost exclusively of short-duration ARM Agency Securities, which reset to more current interest rates within a relatively short period of time and are considered to have limited, if any, credit risk.  See NOTE 1 to the consolidated financial statements (included under Item 1 of this report) for defined terms used in this discussion and analysis.  By investing in short-duration ARM Agency Securities, the Company is positioned to benefit from future recoveries in financing spreads that typically contract during periods of rising interest rates and to 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 finances its residential mortgage investments by leveraging its long-term investment capital with secured borrowings consisting primarily of borrowings under repurchase arrangements with commercial banks and other financial institutions.  Long-term investment capital totaled $1.37 billion at September 30, 2016, consisting of $1.07 billion of common and $198 million of preferred stockholders’ equity together with $98 million of unsecured borrowings maturing in 2035 and 2036 (recorded amounts).  Long-term investment capital decreased by $28 million during the nine months ended September 30, 2016 as increases in unrealized portfolio gains and modest issuances of Series E preferred stock pursuant to an at-the-market continuous offering program were more than offset by unrealized losses on interest rate swap agreements held for hedging purposes and dividend distributions in excess of earnings.  As of September 30, 2016, no shares had been repurchased pursuant the Company’s $100 million common stock repurchase program announced in January 2016.

Capstead’s residential mortgage investments portfolio decreased by 4.0% ($572 million) during the first nine months of 2016 to $13.58 billion at September 30, 2016, primarily as a result of portfolio runoff outpacing acquisitions, particularly during the third quarter.  Secured borrowings declined by 4.1% to $12.43 billion.  Portfolio leverage (secured borrowings divided by long-term investment capital) decreased to 9.09 to one at September 30, 2016 from 9.28 to one at December 31, 2015.  Management believes current portfolio leverage levels represent an appropriate use of leverage under current market conditions for a portfolio consisting of seasoned, short-duration ARM Agency Securities.

Capstead reported net income of $16 million and $65 million or $0.13 and $0.56 per diluted common share for the quarter and nine months ended September 30, 2016, respectively, compared to $21 million and $80 million or $0.18 and $0.72 per diluted common share for the same periods in 2015, respectively.  Earnings in 2016 have been negatively impacted by higher investment premium amortization caused by higher mortgage prepayment levels and higher borrowing costs.  Additionally, third quarter 2016 earnings include a $0.03 per share separation of service charge associated with the July 2016 resignation of the Company’s former President and Chief Executive Officer.  The Company declared a third quarter 2016 common dividend of $0.23 per share that was paid on October 20, 2016 to holders of record on September 30, 2016.

The size and composition of Capstead’s investment portfolio depends on investment strategies being implemented by management, as well as overall market conditions, including the availability of attractively priced investments and suitable financing to leverage the Company’s investment capital.  Market conditions are influenced by, among other things, current and future expectations for short-term interest rates, mortgage prepayments and market liquidity.
 
-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.
 
Common Stock Repurchase Program
 
On January 27, 2016 Capstead’s board of directors authorized the repurchase of up to $100 million in common stock when such repurchases are deemed appropriate relative to portfolio reinvestment options and liquidity needs.  As of November 4, 2016, no shares had been repurchased under this program.

Any repurchases made pursuant to the program will be made in the open market from time to time in accordance with and as permitted by securities laws and other legal requirements.  The timing, manner, price and amount of any repurchases will be determined by the Company in its discretion and will be subject to economic and market conditions, stock price, applicable legal requirements and other factors.  In addition, the Company may enter into Rule 10b5-1 plans under which repurchases can be made. The authorization does not obligate the Company to acquire any particular amount of common stock and repurchases under the program and the program itself may be suspended or discontinued at the Company’s discretion without prior notice.
 
Preferred Equity Capital Issuances
 
During the nine months ended September 30, 2016, Capstead issued an additional 48,000 shares of its 7.50% Series E Cumulative Redeemable Preferred Stock through an at-the-market continuous offering program at an average price of $24.05, net of underwriting fees and other costs, for net proceeds of $1.2 million.  While no shares were issued under this program during the quarter ended September 30, 2016, a modest amount of shares were issued subsequent to quarter-end through November 4, 2016.

Additional amounts of Series E preferred capital may be raised in the future under this program or by other means, subject to market conditions, compliance with federal securities laws and tax regulations as well as blackout periods associated with the dissemination of important Company-specific news.

Book Value per Common Share
 
All but less than $5 million of Capstead’s residential mortgage investments portfolio and all of its interest rate swap agreements are recorded at fair value on the Company’s balance sheet and are therefore included in the calculation of book value per share of common stock (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 recorded at fair value on the balance sheet.  See NOTE 10 to the consolidated financial statements (included under Item 1 of this report) for additional disclosures regarding fair values of financial instruments held by the Company.

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-

 
The following table illustrates the progression of Capstead’s book value per share of common stock as well as changes in book value expressed as percentages of beginning book value for the quarter and nine months ended September 30, 2016:

   
Quarter Ended
September 30, 2016
   
Nine Months Ended
September 30, 2016
 
Book value per common share, beginning of period
 
$
11.21
         
$
11.42
       
Change in unrealized gains and losses on mortgage securities classified as available-for-sale
   
(0.20
)
         
0.11
       
Change in unrealized gains and losses on interest rate swap agreements designated as cash flow hedges of:
                           
Secured borrowings
   
0.19
           
(0.10
)
     
Unsecured borrowings
   
           
(0.17
)
     
     
(0.01
)
   
(0.1
)%
   
(0.16
)
   
(1.4
)%
Capital transactions:
                               
Dividend distributions in excess of earnings
   
(0.10
)
   
(0.9
)%
   
(0.16
)
   
(1.4
)%
Book value per common share, end of period
 
$
11.10
           
$
11.10
         
Decrease in book value per common share during the indicated periods
 
$
(0.11
)
   
(1.0
)%
 
$
(0.32
)
   
(2.8
)%
 
Residential Mortgage Investments
 
The following table illustrates the progression of Capstead’s portfolio of residential mortgage investments for the quarter and nine months ended September 30, 2016 (dollars in thousands):

   
Quarter Ended
September 30, 2016
   
Nine Months Ended
September 30, 2016
 
Residential mortgage investments, beginning of period
 
$
13,901,543
   
$
14,154,737
 
Portfolio acquisitions (principal amount) at average lifetime purchased yields of 2.10% and 2.23%, respectively
   
779,620
     
2,243,808
 
Investment premiums on acquisitions*
   
27,462
     
76,011
 
Portfolio runoff (principal amount)
   
(1,071,071
)
   
(2,807,339
)
Investment premium amortization
   
(36,076
)
   
(95,139
)
(Decrease) Increase in net unrealized gains on securities classified as available-for-sale
   
(19,155
)
   
10,245
 
Residential mortgage investments, end of period
 
$
13,582,323
   
$
13,582,323
 
Decrease in residential mortgage investments during the indicated periods
 
$
(319,220
)
 
$
(572,414
)

*
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’s investment strategy focuses on managing a 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.

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 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.
 
-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).  The Company’s ARM holdings featured the following characteristics at September 30, 2016 (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
 
$
4,132,930
   
2.64
%
   
2.98
%
   
1.70
%
   
3.18
%
   
9.57
%
   
5.9
 
Freddie Mac Agency Securities
   
1,683,157
   
2.74
     
3.16
     
1.82
     
2.67
     
9.61
     
6.9
 
Ginnie Mae Agency Securities
   
1,813,753
   
2.30
     
2.12
     
1.51
     
1.06
     
8.30
     
6.3
 
Residential mortgage loans
   
1,913
   
3.80
     
2.91
     
2.08
     
1.63
     
11.04
     
4.9
 
(57% of total)
   
7,631,753
   
2.58
     
2.82
     
1.68
     
2.57
     
9.27
     
6.2
 
Longer-to-reset ARMs:
                                                     
Fannie Mae Agency Securities
   
2,528,932
   
2.72
     
3.18
     
1.62
     
3.33
     
7.73
     
41.8
 
Freddie Mac Agency Securities
   
2,005,159
   
2.73
     
3.21
     
1.66
     
2.80
     
7.80
     
43.0
 
Ginnie Mae Agency Securities
   
1,248,840
   
2.92
     
2.10
     
1.51
     
1.04
     
7.96
     
41.3
 
(43% of total)
   
5,782,931
   
2.76
     
2.95
     
1.61
     
2.65
     
7.80
     
42.1
 
   
$
13,414,684
   
2.66
     
2.88
     
1.65
     
2.60
     
8.64
     
21.7
 
                                                       
Gross WAC (rate paid by borrowers) (c)
   
3.26
                                         
 
(a)
Amortized cost basis represents the Company’s investment (unpaid principal balance plus unamortized investment premiums) before unrealized gains and losses.  At September 30, 2016, the ratio of amortized cost basis to unpaid principal balance for the Company’s ARM holdings was 103.21.  This table excludes $3 million in fixed-rate agency-guaranteed mortgage pass-through 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.  As such, it is similar to the cash yield on the portfolio which is calculated using amortized cost basis.  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, 71% of current-reset ARMs were subject to periodic caps averaging 1.74%; 20% were subject to initial caps averaging 3.55%; 8% were subject to lifetime caps averaging 7.39%; and 1% were not subject to a cap.  All longer-to-reset ARM securities at September 30, 2016 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.
 
-24-

ARM securities held by Capstead are backed by 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 (a) annually based on specified margins over the one-year London interbank offered rate (“LIBOR”) or the one-year Constant Maturity U.S. Treasury Note Rate (“CMT”), (b) semiannually based on specified margins over six-month LIBOR, or (c) 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.
 
After consideration of any applicable initial fixed-rate periods, at September 30, 2016 approximately 89%, 7% and 4% of the Company’s ARM securities were backed by mortgage loans that reset annually, semi-annually and monthly, respectively.  Approximately 80% 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 September 30, 2016 approximately 8% of the Company’s ARM securities were backed by interest-only loans, with remaining interest-only payment periods averaging 22 months.  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.
 
Secured Borrowings
 
Capstead finances its residential mortgage investments by leveraging its long-term investment capital with secured borrowings consisting primarily of borrowings under repurchase arrangements with commercial banks and other financial institutions.  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 financings.  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.

In August 2015 the Company began supplementing its borrowings under repurchase arrangements with advances from the Federal Home Loan Bank (“FHLB”) of Cincinnati.  On January 12, 2016 the FHLB system regulator finalized rules originally proposed in 2014 that generally preclude captive insurers from remaining members beyond February 19, 2017 with transition rules that require outstanding advances to be repaid upon maturity or by that date.  In response to this action, the Company has migrated all but $250 million of its $2.88 billion of FHLB advances outstanding at December 31, 2015 back to repurchase arrangements and anticipates migrating remaining balances away from the FHLB in November 2016.  FHLB stock held by the Company in connection with advance activity was reduced by $50 million during the nine months ended September 30, 2016 and the remaining $10.0 million held at September 30, 2016 is expected to be redeemed by December 31, 2016.

The terms and conditions of secured borrowings are negotiated on a transaction-by-transaction basis when each such borrowing is initiated or renewed.  None of the Company’s counterparties are obligated to renew or otherwise enter into new borrowings at the conclusion of existing borrowings. Collateral requirements in excess of amounts borrowed (referred to as “haircuts”) averaged 4.6 percent and ranged from 2.0 to 5.0 percent of the fair value of pledged residential mortgage pass-through securities at September 30, 2016.  After considering haircuts and related interest receivable on the collateral, as well as interest payable on these borrowings, the Company had $681 million of capital at risk with its lending counterparties at September 30, 2016.  The Company did not have capital at risk with any single counterparty exceeding 4.7% of total stockholders’ equity at September 30, 2016.
 
-25-

Secured borrowing rates are generally fixed based on prevailing rates corresponding to the terms of the borrowings. Interest may be paid monthly or at the termination of a borrowing at which time the Company may enter into a new borrowing 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 September 30, 2016 the Company’s secured borrowings totaled $12.43 billion with 23 counter-parties at average rates of 0.72%, before the effects of currently-paying interest rate swap agreements held as cash flow hedges and 0.86% including the effects of these derivatives.  To help mitigate exposure to rising short-term interest rates, the Company uses pay-fixed, receive-variable interest rate swap agreements with two- and three-year interest payment terms supplemented with longer-maturity secured borrowings, when available at attractive rates and terms.  Excluding $800 million notional amount of swap agreements that expired October 1, 2016, at quarter-end the Company held $7.05 billion notional amount of portfolio financing-related interest rate swap agreements with contract expirations occurring at various dates through the third quarter of 2019 and a weighted average expiration of 14 months.

After consideration of all portfolio financing-related swap positions entered into as of quarter-end, the Company’s residential mortgage investments and secured borrowings had estimated durations at September 30, 2016 of 10½ and 8 months, respectively, for a net duration gap of approximately 2½ months – see pages 33 and 34 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 its residential mortgage investments by utilizing suitable derivative financial instruments such as interest rate swap agreements as well as longer-maturity secured borrowings, if available at attractive rates and terms.
 
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.  The 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 because secured borrowings generally can be increased or decreased on a daily basis to meet cash flow requirements and otherwise manage capital resources efficiently.  Potential liquidity is affected by, among other factors:
 
·
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,
 
·
mortgage prepayment levels,
 
·
collateral requirements of lending and swap counterparties, and
 
·
general conditions in the commercial banking and mortgage finance industries.
 
-26-

Capstead’s utilization of its long-term investment capital and its estimated potential liquidity were as follows as of September 30, 2016 in comparison with December 31, 2015 (in thousands):

   
Investments (a)
   
Secured
Borrowings
   
Capital
Employed
   
Potential
Liquidity (b)
   
Portfolio
Leverage
 
Balances as of September 30, 2016:
                                 
Residential mortgage investments
 
$
13,582,323
   
$
12,431,839
   
$
1,150,484
   
$
530,789
       
Cash collateral receivable from swap counterparties, net (c)
                   
28,738
     
       
Other assets, net of other liabilities
                 
188,953
     
83,697
       
                 
$
1,368,175
   
$
614,486
   
9.09:1
 
Balances as of December 31, 2015
 
$
14,154,737
   
$
12,958,394
   
$
1,396,310
   
$
702,881
   
9.28:1
 

(a)
Investments are stated at balance sheet carrying amounts, which generally reflect estimated fair value as of the indicated dates.
 
(b)
Potential liquidity is based on maximum amounts of borrowings available under existing uncommitted financing arrangements considering management’s estimate of the fair value of residential mortgage investments held as of the indicated dates adjusted for other sources of liquidity such as cash and cash equivalents.
 
(c)
Cash collateral receivable from swap counterparties is presented net of cash collateral payable to swap counterparties, if applicable, and the fair value of interest rate swap positions as of the indicated date.

In order to efficiently manage its liquidity and capital resources, Capstead attempts to maintain sufficient liquidity reserves to fund borrowing and interest rate swap margin calls under stressed market conditions, including margin calls resulting from monthly principal payments (remitted to the Company 20 to 45 days after any given month-end), as well as reasonably possible declines in the market value of pledged assets and swap positions.  Should market conditions deteriorate, management may reduce portfolio leverage and increase liquidity by raising new equity capital, selling mortgage securities and/or curtailing the replacement of portfolio runoff.  Additionally, the Company routinely does business with a large number of lending counterparties, which bolsters financial flexibility to address challenging market conditions and limits exposure to any individual counterparty.

Future levels of portfolio leverage will be dependent on many factors, including the size and composition of the Company’s investment portfolio (see “Liquidity and Capital Resources”).  Portfolio leverage decreased from year-end primarily because of lower borrowing requirements resulting from a 4.0% decline in portfolio balances that was partially offset by a $28 million reduction in long-term investment capital.  Potential liquidity declined during this period due largely to higher mortgage securities principal remittance receivables as a result of higher levels of portfolio runoff, capital deployed to support swap positions and the decline in long-term investment capital.  Management believes current portfolio leverage levels represent an appropriate use of leverage under current market conditions for a portfolio consisting of seasoned, short-duration ARM Agency Securities.
 
-27-

Supplemental Analysis of Quarterly Financing Spreads
 
Quarterly financing spreads and mortgage prepayment rates were as follows for the indicated periods:

   
2016
   
2015
   
2014
 
     
Q3
     
Q2
     
Q1
     
Q4
     
Q3
     
Q2
     
Q1
     
Q4
 
Total financing spreads: (a)
                                                               
Yields on all interest-earning assets
   
1.45
%
   
1.53
%
   
1.69
%
   
1.62
%
   
1.40
%
   
1.42
%
   
1.66
%
   
1.61
%
Borrowing rates on all interest-paying liabilities
   
0.89
     
0.89
     
0.87
     
0.79
     
0.74
     
0.68
     
0.65
     
0.63
 
Total financing spreads
   
0.56
     
0.64
     
0.82
     
0.83
     
0.66
     
0.74
     
1.01
     
0.98
 
Financing spreads on residential mortgage investments, a non-  GAAP financial measure:
                                                               
Cash yields on residential mortgage investments (b)
   
2.52
     
2.50
     
2.47
     
2.44
%
   
2.42
%
   
2.41
%
   
2.42
%
   
2.43
%
Investment premium amortization (b)
   
(1.06
)
   
(0.96
)
   
(0.75
)
   
(0.81
)
   
(0.99
)
   
(0.95
)
   
(0.72
)
   
(0.77
)
Yields on residential mortgage investments
   
1.46
     
1.54
     
1.72
     
1.63
     
1.43
     
1.46
     
1.70
     
1.66
 
Unhedged secured borrowing rates (c)
   
0.69
     
0.67
     
0.65
     
0.48