UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

FORM 10-Q

þ	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended:  September 30, 2014

OR

o	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 þ NO o

 

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 þ NO o

 

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 þ

Accelerated filer o

Non-accelerated filer o

Smaller reporting company o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  YES o NO þ

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 SEPTEMBER 30, 2014

INDEX

PART I. ¾ FINANCIAL INFORMATION

 

 

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PART I. ¾ FINANCIAL INFORMATION

 

CAPSTEAD MORTGAGE CORPORATION

CONSOLIDATED BALANCE SHEETS

(in thousands, except per share amounts)

 

 

See accompanying notes to consolidated financial statements.

 

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CAPSTEAD MORTGAGE CORPORATION

CONSOLIDATED STATEMENTS OF INCOME

(in thousands, except per share amounts)

(unaudited)

 

 

See accompanying notes to consolidated financial statements.

 

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CAPSTEAD MORTGAGE CORPORATION

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(in thousands, unaudited)

 

See accompanying notes to consolidated financial statements.

 

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CAPSTEAD MORTGAGE CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands, unaudited)

 

 

See accompanying notes to consolidated financial statements.

 

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CAPSTEAD MORTGAGE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2014

(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 or Freddie Mac (together, the “GSEs”), or by an agency of the federal government, Ginnie Mae.  Residential mortgage pass-through securities guaranteed by the GSEs 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 nine months ended September 30, 2014 are not necessarily indicative of the results that may be expected for the calendar year ending December 31, 2014.  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, 2013.  Certain prior period short- and long-term incentive compensation amounts have been reclassified from Salaries and benefits to separate line items in the Statements of Income to conform to the current year presentation.

Recent Accounting Pronouncements

In June 2014 the Financial Accounting Standards Board issued ASU 2014-11, Transfers and Servicing:  Repurchase-to-Maturity Transactions, Repurchase Financings and Disclosures (the “ASU”).  The ASU 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.  The ASU also introduces new disclosure requirements and is effective for periods beginning after December 15, 2014.  Adoption of the ASU is not expected to have any effect on Capstead’s financial statements.

NOTE 3 ¾ NET INCOME PER COMMON SHARE

Basic net income per common share is computed by dividing net income, after deducting preferred share dividends and adjusting for the impact of unvested stock awards deemed to be participating securities, by the weighted average number of common shares outstanding, calculated excluding unvested stock awards.

 

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Diluted net income per common share is computed by dividing net income available to common stockholders, after adding dividends on the Company’s Series A and B convertible preferred shares (prior to their redemption in June 2013 and when such shares were dilutive), by the basic weighted average number of common shares and common share equivalents outstanding, giving effect to equity awards and convertible preferred shares when such awards and shares were dilutive.  The Series A and B preferred shares were considered dilutive whenever basic net income per common share exceeded each Series’ dividend divided by the applicable conversion rates.  Shares of the Company’s 7.50% Series E Cumulative Redeemable Preferred Stock first issued in May 2013 are contingently convertible into common shares only upon the occurrence of a change in control and are therefore not considered dilutive securities absent such an occurrence.  Unvested stock 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 for the indicated periods were as follows (dollars in thousands, except per share amounts):

 

Potentially dilutive securities excluded from the computation of net income per share because the effect of inclusion was antidilutive were as follows (in thousands):

 

 

*

The Series A and Series B preferred shares were redeemed in June 2013 (See NOTE 9).

 

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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 10).

(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 the GSEs, 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 289 months.

 

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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 securities based on each security’s 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 securities have months to roll of less than 18 months while longer-to-reset ARM securities have months to roll of 18 months or greater.  As of September 30, 2014, the average months to roll for the Company’s $7.61 billion (amortized cost basis) in current-reset ARM securities was 6.2 months while the average months-to-roll for the Company’s $5.86 billion (amortized cost basis) in longer-to-reset ARM securities was 39.8 months.

NOTE 5 ¾ INVESTMENTS IN UNCONSOLIDATED AFFILIATES

To facilitate the issuance of Unsecured borrowings, in 2006 and 2005 Capstead formed and capitalized three Delaware statutory trusts through the issuance to the Company of the trusts’ common securities totaling $3.1 million (see NOTE 8).  In December 2013 the Company simplified its capital structure by dissolving the trusts and distributing the related junior subordinated notes (originally issued to the trusts by the Company) to the holders of the trusts’ common and preferred securities.  Prior to dissolution, the Company’s equity in the earnings of the trusts consisted solely of the common trust securities’ pro rata share in interest accruing on junior subordinated notes issued to the trusts.

NOTE 6 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, typically with terms of 30 to 90 days, and are accounted for as borrowings.  The Company maintains the beneficial interest in the specific securities pledged during the borrowing’s term of the repurchase arrangement and receives the related principal and interest payments.  The amount borrowed is generally equal to the fair value of the assets 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 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.  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 release posted collateral.

 

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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):

 

 

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NOTE 7 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 nine months ended September 30, 2014 Capstead entered into new forward-starting swap agreements with notional amounts totaling $500 million and $1.90 billion, respectively.  These swap agreements require fixed rate interest payments averaging 0.72% and 0.61%, respectively, for two-year periods commencing on various dates between April 2014 and January 2015.  Also during these periods, $200 million and $800 million notional amount of swaps requiring fixed rate interest payments averaging 0.51% and 0.53%, respectively, matured, while $700 million and $3.50 billion notional amount of previously-acquired, forward-starting swaps requiring fixed rate interest payments averaging 0.56% and 0.51%, respectively, moved into current-pay status.  At September 30, 2014, 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 2015 and September 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 8).

 

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Interest rate swap agreements are measured at fair value on a recurring basis primarily using Level Two Inputs in accordance with “Fair Value Measurements and Disclosures” (“ASC 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 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):

 

 

(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 $15.5 million at September 30, 2014.

(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.

 

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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 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 $8.9 million and $5.5 million on interest rate swap agreements and $2.5 million and $4.7 million on repurchase arrangements and similar borrowings, included in “Accounts payable and accrued expenses” on the face of the Balance Sheets as of September 30, 2014 and December 31, 2013, 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.

 

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Changes in Accumulated other comprehensive income by component for the quarter and nine months ended September 30, 2014 were as follows (in thousands):

 

 

NOTE 8 ¾ UNSECURED BORROWINGS

Unsecured borrowings consist of 30-year junior subordinated notes originally issued in 2005 and 2006 to three special-purpose statutory trusts formed to issue $3.1 million of the trusts’ common securities to Capstead and to privately place $100 million of so-called trust preferred securities with unrelated third party investors.  In December 2013 the statutory trusts were dissolved after the subordinated notes were distributed to the holders of the trusts’ common and preferred securities.  Included in Receivables and other assets are $2.1 million in remaining issue costs at September 30, 2014 associated with the original issuance of these notes.  Note balances and related weighted average interest rates as of September 30, 2014 and December 31, 2013 (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 in October and December 2015 for the notes associated with Capstead Mortgage Trusts I and II and September 2016 for the notes associated with Capstead Mortgage Trust III, the effective borrowing rate during the final 20 years of these borrowings will average 7.56%, subject to certain adjustments for the effects of measured hedge ineffectiveness, if any.

The notes associated with Capstead Mortgage Trust I mature in October 2035 and are currently redeemable, in whole or in part, without penalty, at the Company’s option.  The notes associated with Capstead Mortgage Trust II mature in December 2035 and are redeemable, in whole or in part, without penalty, at the Company’s option anytime on or after December 15, 2015.  The notes associated with Capstead Mortgage Trust III mature in September 2036 and are redeemable, in whole or in part, without penalty, at the Company’s option anytime on or after September 15, 2016.

 

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NOTE 9 ¾ CAPITAL TRANSACTIONS

In May 2013 Capstead completed a public offering of 6.8 million shares ($170.0 million face amount) of its 7.50% Series E Cumulative Redeemable Preferred Stock, liquidation preference $25.00 per share.  The Series E preferred shares are redeemable at the Company’s option for $25.00 per share, plus any accumulated and unpaid dividends, on or after May 13, 2018.  Proceeds of the offering after underwriting fees and other costs totaled $164.3 million and together with $42.7 million of cash on hand were used to fund the June 2013 redemption of the Company’s Series A and B perpetual preferred shares.  The preferred shares that were redeemed had redemption preferences aggregating $207.0 million, a total of $19.9 million in excess of these shares’ recorded amounts on the Company’s balance sheet.  This redemption preference premium is reflected as a $0.21 per common share reduction in net income available to common stockholders on the face of the Company’s Statements of Income for the nine months ended September 30, 2013.

 

In late 2013 the Company began issuing additional Series E preferred shares through an at-the-market continuous offering program.  During the quarter and nine months ended September 30, 2014, the Company issued 105,000 and 683,000 Series E preferred shares at average prices of $23.82 and $23.94, net of expenses, for net proceeds of $2.5 million and $16.3 million, respectively.  No Series E preferred shares were issued subsequent to quarter-end through November 5, 2014.

 

Between November 2012 and January 2013, the Company repurchased 3.6 million common shares at a cost of $42.4 million pursuant to a $100 million common share repurchase program.  In July 2014 this program was suspended indefinitely.

 

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 earnings and dividend announcements and other important Company-specific news.

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.  All fair values were determined using Level 2 Inputs in accordance with ASC 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 120 days or less.  See NOTE 7 for information relative to the valuation of interest rate swap agreements.

 

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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 seasoned, 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.

 

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From a credit risk perspective, federal government support for the GSEs 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 September 30, 2014.

NOTE 11 ¾ COMPENSATION PROGRAMS

The compensation committee of Capstead’s board of directors (the “Committee”) administers all compensation programs for employees including salaries, short- and long-term incentive compensation, including equity-based awards, as well as other benefit programs.  After reviewing existing programs and practices and soliciting feedback from investors during 2013, the Committee made a number of important changes that became effective in 2013 and early 2014.  The most prominent changes involved replacing an absolute return-based but discretionary bonus program with a largely nondiscretionary and formulaic, target-based annual incentive compensation program focusing more on relative return metrics and implementing a new performance-based long-term incentive compensation program.

Short-term Incentive Compensation Programs

Through June 30, 2013, the Committee utilized an incentive formula that allowed for participation in Capstead’s earnings in excess of a pre-established performance threshold, subject to a maximum amount, or cap.  Awards made under this annual incentive compensation program were at the Committee’s discretion as to (i) the amount actually awarded, (ii) its allocation among executives and with other employees and (iii) the form of payment (e.g., cash or equity awards).  This program was replaced with a new annual incentive compensation program for key executives referred to as the “2013 Program.”  The 2013 Program determined levels of annual cash incentive compensation based on relative performance metrics measured against the Company’s peers in the mortgage REIT industry and the attainment of individual goals and objectives for participating executives.  The relative performance metrics used were relative economic return (change in book value plus dividends) and relative operating efficiency (operating expenses divided by Unsecured borrowings and Stockholders’ equity), calculated for the full year and prorated for the six month period during which the program was effective in 2013.  The 2013 Program defined maximum payout percentages based on a multiple of salary for each program metric thereby limiting the amount payable to each participating executive.  For 2014 the Committee added an absolute economic return performance metric to this program which measures performance against established return levels.

 

Included in Accounts payable and accrued expenses at September 30, 2014 are accruals totaling $1.1 million for the 2014 annual incentive compensation program as well as separately determined bonus amounts for officers and employees not participating in this program.  Recognized in Short-term incentive compensation are $391,000 and $883,000 related to these programs for the quarter and nine months ended September 30, 2014, respectively.

 

In 2008 the Committee instituted 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 or “phantom” common shares (“Dividend Equivalent Rights” or “DERs”).  DERs are not attached to any stock or option awards and 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.  DERs outstanding at September 30, 2014 totaled 654,000.  All grants expire July 1, 2015.  Included in Accounts payable and accrued expenses are third quarter 2014 DERs distribution amounts totaling $222,000 that were paid in October 2014.  Recognized in Short-term incentive compensation are $222,000 and $667,000 related to the DERs program for the quarter and nine months ended September 30, 2014, respectively.

 

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Long-term Equity-based Incentive Awards

Capstead sponsors equity-based award plans to provide for the issuance of stock awards, restricted stock unit awards, option awards and other long-term equity-based incentive awards to directors and employees.  In May 2014 stockholders approved the Amended and Restated 2014 Flexible Incentive Plan, which provides for the issuance of up to five million common shares pursuant to future 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. At September 30, 2014, the Plan had 4,965,000 common shares remaining available for future issuances.

 

In December 2013 the Committee adopted a new performance-based long-term incentive compensation program granting key executives a total of 242,505 restricted stock units.  These units are convertible into common shares following a three-year performance period ending December 31, 2016 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).  An absolute economic return metric measures performance against established 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 common shares the units can convert into for each of the metrics, if any, can range from one-half of a common share per unit if that metric’s minimum threshold of performance is met, to two common 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 common shares based on the number of common shares ultimately issued, if any.

 

Under a prior absolute return performance-based stock award program, the Committee granted stock awards from 2008 through 2012 to all employees with staggered three-year vesting periods subject to Capstead generating annualized returns in excess of established return levels.  If the required returns are not generated during a three-year measurement period, vesting will be deferred and a new three-year measurement period will be 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.  Information pertaining to absolute return performance-based stock awards issued to employees pursuant to this program is as follows:

 

 

(a)

The absolute return metrics for the three-year measurement periods ending December 31, 2012 and 2011 were met resulting in the vesting of 67,595 shares associated with the second 50% of this grant in January 2013 and 67,599 shares associated with the first 50% of this grant in February 2012.

(b)

The absolute return metrics for the three-year measurement periods ending December 31, 2013 and 2012 were met resulting in the vesting of 52,915 shares associated with the second 50% of this grant in January 2014 and 53,431 shares associated with the first 50% of this grant in January 2013.

(c)

The absolute return metric for the first three-year measurement period ending December 31, 2013 was met resulting in the vesting of 61,508 shares associated with the first 50% of this grant in January 2014.

 

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In December 2013 the Committee granted service-based stock awards for 35,703 common shares with a grant date fair value of $12.34 to employees that weren’t awarded performance-based restricted stock units.  These awards vest January 2, 2017.  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 April 2014, director grants awarded in 2013 for 28,000 shares with a grant date fair value of $13.02 vested.  In July 2014, director stock awards for 35,000 shares with a grant date fair value of $13.16 were granted that vest in July 2015.  In January 2014 the remaining 22,164 shares associated with 2007 service-based stock awards issued to all employees vested.

 

Performance-based and service-based stock award activity for quarter and nine months ended September 30, 2014 is summarized below:

 

 

During the quarter and nine months ended September 30, 2014, the Company recognized in Long-term incentive compensation $372,000 and $1.1 million, respectively, related to amortization of the grant date fair value of employee performance-based and service-based stock awards.  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 $77,000 and $199,000 related to amortization of the grant date fair value of service-based director stock awards during the quarter and nine months ended September 30, 2014, respectively.  Unrecognized compensation expense for unvested stock awards totaled $1.8 million as of September 30, 2014, to be expensed over a weighted average period of 1.3 years (assumes minimal employee and director attrition and, if applicable, absolute return performance metrics being met for related initial measurement periods).

 

During the quarter and nine months ended September 30, 2014 the Company recognized in Long-term incentive compensation $252,000 and $755,000, respectively, related to the performance-based restricted stock units granted in December 2013.  A grant date fair value of $12.45 was assigned to each unit based on estimated outcomes for each nonmarket-based performance metric and a Monte Carlo simulation for the relative total stockholder return performance metric.  Assuming certain targeted performance levels are achieved and there are no forfeitures, $3.0 million can be expected to be expensed over the related three-year performance period.  However, the value associated with the nonmarket-based performance metrics is subject to change over the units’ performance period.  Actual expense assuming no forfeitures will range from a minimum of $625,000 (the grant date fair value of the total stockholder return performance metric and assuming no shares are ultimately issued under the terms of these grants because the Company’s performance for all performance metrics was less than the related minimum threshold performance levels) to approximately $5.4 million assuming maximum performance levels are met or exceeded for all performance metrics resulting in the issuance of 485,010 common shares.

 

All service-based stock awards receive dividends on a current basis without risk of forfeiture if the related awards do not vest.  All outstanding performance-based stock awards and restricted stock units defer the payment of dividends accruing between the grant dates and the end of related performance periods.  If performance-based stock awards do not vest or to the extent restricted stock units do not convert into common shares, the related accrued dividends will be forfeited.  Included in Common stock dividend payable at September 30, 2014 is estimated dividends payable pertaining to these awards totaling $1.6 million.

 

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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 the Company’s common shares on the date of grant.  The fair value of option awards was estimated on the date of grant using a Black-Scholes option pricing model.  The Company estimated option exercises, expected holding periods and forfeitures based on past experience and expectations for option performance and employee or director attrition.  Risk-free rates were based on market rates for the expected life of the options.  Expected dividends were based on historical experience and expectations for future performance.  Expected volatility factors were based on historical experience.  No option awards have been granted since 2010.

 

Option award activity for the nine months ended September 30, 2014 is summarized below:

 

 

All outstanding option awards are exercisable at September 30, 2014.  These awards have a weighted average remaining contractual term of 3.7 years and an aggregate intrinsic value of $25,000.

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 nine months ended September 30, 2014, the Company recognized in Salaries and benefits $68,000 and $187,000, respectively, related to contributions to these plans.

 

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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 (a) benefit from potential recoveries in financing spreads that typically contract during periods of rising interest rates and (b) 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 and a shorter duration generally indicates less interest rate risk.

 

Capstead finances its portfolio of ARM Agency Securities with borrowings under repurchase arrangements with commercial banks and other financial institutions supported by its long-term investment capital, which as of September 30, 2014 totaled $1.50 billion and consisted of $1.21 billion of common and $182 million of perpetual preferred stockholders’ equity (recorded amounts) and $100 million of unsecured borrowings that mature in 2035 and 2036.  Long-term investment capital increased by $30 million during the nine months ended September 30, 2014 primarily as a result of higher portfolio pricing levels and Series E preferred capital raised using an at-the-market continuous offering program, partially offset by lower pricing levels for interest rate swap agreements held for hedging purposes and dividend distributions in excess of earnings.

 

Capstead’s holdings of residential mortgage investments increased by $246 million during the nine months ended September 30, 2014 to $13.72 billion, with portfolio acquisitions exceeding portfolio runoff by $215 million (principal amount) and the remainder primarily attributable to a small increase in overall portfolio pricing levels.  Borrowings under repurchase arrangements increased by $267 million during the nine months ended September 30, 2014 to $12.75 billion.  Portfolio leverage (borrowings under repurchase arrangements divided by long-term investment capital) was unchanged from year-end at 8.52 to one at September 30, 2014.  Management believes borrowing at current levels represents an appropriate and prudent use of leverage for a portfolio of Agency Securities under current market conditions, particularly for a portfolio consisting almost entirely of seasoned, short-duration ARM Agency Securities.

 

Capstead reported net income of $32 million and $107 million or $0.30 and $1.02 per diluted common share for the quarter and nine months ended September 30, 2014, respectively, compared to $25 million and $90 million or $0.23 and $0.58 per diluted common share for the same periods in 2013.  Results for the nine months ended September 30, 2013 include certain one-time effects on net income available to common stockholders of second quarter 2013 preferred capital redemption and issuance transactions totaling $0.23 per common share.

 

Higher earnings in 2014 reflect improved financing spreads primarily as a result of lower investment premium amortization because of lower mortgage prepayment rates.  Mortgage prepayment rates began declining in September 2013 and reached a two-year low in the first quarter of 2014 largely because of higher prevailing mortgage interest rates, which made it less economically advantageous for mortgagors to refinance.  Average borrowing rates remained stable for the first two quarters of 2014 before increasing two basis points during the third quarter and were marginally lower than rates in effect during the nine months ended September 30, 2013.

 

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Capstead remains a clear leader among its mortgage REIT peers in terms of operating efficiency.  Operating costs (salaries and benefits, incentive compensation and other general and administrative expense) expressed as an annualized percentage of long-term investment capital averaged 87 basis points for both the quarter and nine months ended September 30, 2014, compared to 89 basis points for all of 2013.

 

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 levels of, and expectations for future levels of, short-term interest rates, mortgage prepayments and market liquidity.

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

In May 2013 Capstead completed a public offering of 6.8 million shares ($170 million face amount) of its 7.50% Series E Cumulative Redeemable Preferred Stock, liquidation preference $25.00 per share.  Proceeds of the offering, after underwriting fees and other expenses, totaled $164 million and together with $43 million of cash on hand were used to fund the June 2013 redemption of the Company’s Series A and B perpetual preferred shares.  The preferred shares that were redeemed had preferences aggregating $207 million, a total of approximately $20 million in excess of these shares’ recorded amounts on the Company’s balance sheet.  This redemption preference premium is reflected as a $0.21 per common share reduction in net income available to common stockholders on the face of the Company’s Statements of Income for the nine months ended September 30, 2013.

 

In late 2013 the Company began issuing additional Series E preferred shares through an at-the-market continuous offering program.  During the quarter and nine months ended September 30, 2014, the Company issued 105,000 and 683,000 Series E preferred shares at an average price of $23.82 and $23.94, net of expenses, for net proceeds of approximately $3 million and $16 million, respectively.  No Series E preferred shares were issued subsequent to quarter-end through November 5, 2014.

 

Between November 2012 and January 2013, the Company repurchased 3.6 million common shares at a cost of $42 million pursuant to a $100 million common share repurchase program.  In July 2014 this program was suspended indefinitely.

 

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 earnings and dividend announcements and other important Company-specific news.

Book Value per Common Share

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 aggregate liquidation preferences for preferred shares, divided by common shares outstanding).  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.

 

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Capstead’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.

The following table illustrates the progression of the Capstead’s book value per common share for the quarter and nine months ended September 30, 2014: