EXHIBIT 13
PORTIONS OF THE
ANNUAL REPORT TO STOCKHOLDERS
FOR THE YEAR ENDED DECEMBER 31, 1993
EXHIBIT 13
REPORT OF ERNST & YOUNG, INDEPENDENT AUDITORS
Stockholders and Board of Directors
Capstead Mortgage Corporation
We have audited the accompanying consolidated balance sheet of Capstead Mortgage
Corporation and subsidiaries as of December 31, 1993 and 1992, and the related
consolidated statements of income, stockholders' equity, and cash flows for each
of the three years in the period ended December 31, 1993. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of
Capstead Mortgage Corporation and subsidiaries at December 31, 1993 and 1992,
and the consolidated results of their operations and their cash flows for each
of the three years in the period ended December 31, 1993, in conformity with
generally accepted accounting principles.
ERNST & YOUNG
Dallas, Texas
January 24, 1994
23
CAPSTEAD MORTGAGE CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF INCOME
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
Year Ended December 31
--------------------------------
1993 1992 1991
-------- -------- --------
Interest income:
Mortgage securities collateral $390,690 $383,060 $176,578
Mortgage investments 184,136 117,527 58,989
-------- -------- --------
Total interest income 574,826 500,587 235,567
-------- -------- --------
Interest and related expenses:
Collateralized mortgage securities:
Interest 382,065 353,356 158,366
Additional amortization of
discount 28,088 -- --
Short-term borrowings 80,923 62,077 31,474
Mortgage insurance and other 20,084 13,821 3,118
Provision for possible losses 2,800 7,750 1,707
-------- -------- --------
Total interest and related expenses 513,960 437,004 194,665
-------- -------- --------
Net margin on mortgage assets 60,866 63,583 40,902
-------- -------- --------
Other revenues:
Gain on sales 61,216 2,910 1,379
Mortgage servicing revenues 2,574 -- --
Other 2,887 952 1,303
-------- -------- --------
66,677 3,862 2,682
-------- -------- --------
Other expenses:
Management fees 4,275 5,909 4,363
Manager termination costs 11,891 -- --
Salaries and related costs 8,295 4,124 2,694
General and administrative 7,343 4,221 2,810
Amortization of purchased mortgage
servicing rights 1,483 -- --
-------- -------- --------
Total other expenses 33,287 14,254 9,867
-------- -------- --------
Net income $ 94,256 $ 53,191 $ 33,717
======== ======== ========
Net income $ 94,256 $ 53,191 $ 33,717
Less cash dividends on preferred stock (38,592) (4,707) (7,499)
-------- -------- --------
Net income available to common
stockholders $ 55,664 $ 48,484 $ 26,218
======== ======== ========
Net income per share:
Primary $ 3.68 $ 3.37 $ 2.92
Fully diluted 3.57 3.23 2.46
Average number of shares outstanding:
Primary 15,146 14,394 8,964
Fully diluted 15,930 15,591 13,683
Cash dividends paid per share:
Common $ 3.66 $ 3.26 $ 2.56
Series A Preferred 1.60 1.60 1.60
Series B Preferred 1.26 0.10 --
See notes to accompanying consolidated financial statements.
24
CAPSTEAD MORTGAGE CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
(IN THOUSANDS)
December 31
-----------------------
1993 1992
---------- ----------
ASSETS
Mortgage securities collateral $3,962,680 $5,269,600
Mortgage investments 2,875,427 1,904,600
---------- ----------
6,838,107 7,174,200
Less allowance for possible losses (6,927) (8,228)
---------- ----------
6,831,180 7,165,972
Cash and cash equivalents 87,760 30,302
Prepaids, receivables and other 32,421 33,334
Purchased mortgage servicing rights 28,963 --
---------- ----------
$6,980,324 $7,229,608
========== ==========
LIABILITIES
Collateralized mortgage securities $3,891,134 $5,143,157
Repurchase arrangements 2,443,807 1,449,209
Accounts payable and accrued expenses 7,193 5,743
---------- ----------
6,342,134 6,598,109
---------- ----------
STOCKHOLDERS' EQUITY
Preferred stock - $0.10 par value;
100,000 shares authorized:
$1.60 Cumulative Preferred Stock,
Series A, 735 and 942 shares
issued and outstanding ($12,054
aggregate liquidation preference) 10,295 13,205
$1.26 Cumulative Convertible Preferred
Stock, Series B, 29,797 shares and
29,430 shares issued and outstanding
($339,090 aggregate liquidation
preference) 319,543 315,025
Common stock - $0.01 par value; 100,000 shares
authorized; 15,154 and 14,894 shares issued
and outstanding 152 149
Paid-in capital 308,140 303,503
Undistributed income (deficit) 60 (383)
---------- ----------
638,190 631,499
---------- ----------
$6,980,324 $7,229,608
========== ==========
See notes to accompanying consolidated financial statements.
25
CAPSTEAD MORTGAGE CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
(IN THOUSANDS)
Three Years Ended December 31, 1993
---------------------------------------------------------------------------------------------------
Shares Outstanding Stated Value
----------------------------- --------------------------------
Preferred Preferred Undistributed
-------------------- ----------------------- Paid-in Income
Series A Series B Common Series A Series B Common Capital (Deficit) Total
-------- -------- ------ -------- -------- ------ ------- --------- -----
Balance at
January 1, 1991 5,465 -- 8,700 $ 76,706 $ -- $ 87 $177,076 $ (2,846) $251,023
Net income -- -- -- -- -- -- -- 33,717 33,717
Cash dividends:
Common -- -- -- -- -- -- -- (24,287) (24,287)
Preferred -- -- -- -- -- -- -- (7,499) (7,499)
Conversion of
preferred stock (3,140) -- 2,827 (44,090) -- 28 44,062 -- --
Other -- -- 27 -- -- 1 384 -- 385
-------- -------- ------ -------- -------- ------ ------- -------- -----
Balance at
Dec. 31, 1991 2,325 -- 11,554 32,616 -- 116 221,522 (915) 253,339
Stock issuance -- 29,430 2,046 -- 315,025 20 61,623 -- 376,668
Net income -- -- -- -- -- -- -- 53,191 53,191
Cash dividends:
Common -- -- -- -- -- -- -- (47,952) (47,952)
Preferred:
Series A -- -- -- -- -- -- -- (1,823) (1,823)
Series B -- -- -- -- -- -- -- (2,884) (2,884)
Conversion of
preferred stock (1,383) -- 1,244 (19,411) -- 12 19,399 -- --
Other -- -- 50 -- -- 1 959 -- 960
-------- -------- ------ -------- -------- ------ ------- -------- -----
Balance at
Dec. 31, 1992 942 29,430 14,894 13,205 315,025 149 303,503 (383) 631,499
Net income -- -- -- -- -- -- -- 94,256 94,256
Cash dividends:
Common -- -- -- -- -- -- -- (55,221) (55,221)
Preferred:
Series A -- -- -- -- -- -- -- (1,274) (1,274)
Series B -- -- -- -- -- -- -- (37,318) (37,318)
Conversion of
preferred stock (207) (14) 191 (2,910) (144) 2 3,052 -- --
Other -- 381 69 -- 4,662 1 1,585 -- 6,248
-------- -------- ------ -------- -------- ------ ------- -------- -----
Balance at
Dec. 31, 1993 735 29,797 15,154 $ 10,295 $319,543 $152 $308,140 $ 60 $638,190
======== ======== ====== ======== ======== ====== ======= ======== =====
See notes to accompanying consolidated financial statements.
26
CAPSTEAD MORTGAGE CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS
(IN THOUSANDS)
Year Ended December 31
-----------------------------------------
1993 1992 1991
----------- ----------- -----------
OPERATING ACTIVITIES:
Net income $ 94,256 $ 53,191 $ 33,717
Noncash items:
Amortization of
discount and premium 47,988 7,398 1,405
Amortization of purchased
mortgage servicing rights 1,483 -- --
Provision for possible losses 2,800 7,750 1,707
Net change in prepaids,
receivables, other assets
and payables 2,363 (19,681) (6,113)
Net gain from investing
activities (61,216) (2,910) (1,379)
----------- ----------- -----------
Net cash provided by
operating activities 87,674 45,748 29,337
----------- ----------- -----------
INVESTING ACTIVITIES:
Mortgage securities collateral:
Principal collections
on collateral 2,437,768 1,270,681 297,147
Decrease (increase) in
accrued interest receivable 11,302 (13,947) (8,957)
Increase in short-term
investments (25,361) (98,242) (37,484)
Purchases of mortgage loans (4,410,950) (5,489,456) (2,173,149)
Purchases of agency securities (1,747,931) -- (157,214)
Purchases of mortgage
servicing rights (30,446) -- --
Principal collections on
mortgage loans 266,347 99,447 49,752
Proceeds from sales of mortgage
assets 3,859,993 1,160,920 71,720
Net cash from acquisition -- 8,236 --
----------- ----------- -----------
Net cash provided (used)
by investing activities 360,722 (3,062,361) (1,958,185)
----------- ----------- -----------
FINANCING ACTIVITIES:
Collateralized mortgage
securities:
Issuance of securities 1,185,482 3,564,780 1,485,031
Principal payments on
securities (2,469,026) (1,168,581) (259,517)
Increase (decrease)
in accrued interest payable (14,427) 21,396 11,863
Capital stock transactions 6,248 62,603 385
Dividends paid (93,813) (52,659) (31,786)
Increase in short-term
borrowings 994,598 593,637 747,406
----------- ----------- -----------
Net cash provided (used) by
financing activities (390,938) 3,021,176 1,953,382
----------- ----------- -----------
Net increase in cash and cash
equivalents 57,458 4,563 24,534
Cash and cash equivalents at
beginning of year 30,302 25,739 1,205
----------- ----------- -----------
Cash and cash equivalents at end
of year $ 87,760 $ 30,302 $ 25,739
=========== =========== ===========
See notes to accompanying consolidated financial statements.
27
CAPSTEAD MORTGAGE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1993
NOTE A -- BUSINESS
Capstead Mortgage Corporation, together with certain affiliated entities,
operates as a mortgage conduit which purchases and securitizes various types of
single-family residential mortgage loans. In addition, the Company has formed a
mortgage servicing unit to function as the primary mortgage servicer and master
servicer for loans and servicing rights acquired by the Company. The Company
offers investors the opportunity to participate in the income generated from
servicing and investing in mortgage loans, securitization activities and other
portfolio strategies.
NOTE B -- ACCOUNTING POLICIES
Principles of Consolidation
The consolidated financial statements include the accounts of Capstead Mortgage
Corporation ("Capstead"), its special-purpose finance subsidiaries and certain
other entities (collectively, the "Company"). Intercompany balances and
transactions have been eliminated. Substantially all of the assets of the
special-purpose finance subsidiaries are pledged to secure the issuance of
mortgage pass-through securities and collateralized mortgage securities and are
not available for the satisfaction of general claims of Capstead. Capstead has
no obligation for the mortgage pass-through securities and collateralized
mortgage securities beyond the assets pledged as collateral.
Mortgage Assets
Substantially all mortgage securities collateral and mortgage investments are
carried at their unpaid principal balances, net of unamortized discount or
premium and adjusted for deferred hedging gains or losses, if any. The Company
may, from time to time, hold loans for sale. Loans held for sale are carried at
the lower of cost or market on an aggregate basis. The cost of these mortgage
loans is adjusted for gains or losses generated from corresponding hedging
transactions prior to the lower of cost or market valuation. Transfers from
loans held for sale to loans held for investment are recorded at the lower of
cost or market. Interest income, net of servicing fees, is recorded as income
when earned. Any discount or premium is recognized as an adjustment to interest
income by the interest method over the life of the related mortgage loan.
Included in mortgage securities collateral are other mortgage securities
consisting primarily of interest-only and principal-only securities. Interest-
only securities represent ownership of an undivided interest in interest
payments on the underlying securities. Principal-only securities represent
ownership of an undivided interest in principal payments on the underlying
securities. Other mortgage securities are carried at the present value of the
future cash flows expected to be received during the remaining term of the
investment, discounted at a constant effective yield. Income (loss) recognized
on other mortgage securities is the difference between the actual cash received
and the reduction in the carrying value.
28
Mortgage assets may be subject to changes in value because of changes in
interest rates and/or rates of prepayment, as well as the risk that the
mortgagor may fail to perform under the mortgage agreement. The Company manages
its exposure to these risks by the issuance of mortgage pass-through securities
or collateralized mortgage securities, the acquisition of mortgage pool
insurance, forward sale agreements and other appropriate strategies.
The fair value of mortgage assets at December 31, 1993 was estimated using
either (i) quoted market prices when available including quotes made by the
Company's lenders in connection with designating collateral for repurchase
arrangements, (ii) offer prices by the Company for similar mortgage assets, or
(iii) expected securitization results. The fair value for other mortgage
securities was estimated using discounted cash flow analyses based on current
interest rates and prepayment expectations.
Hedging Activities
The Company may enter into forward sale agreements for the purpose of reducing
exposure to the effect of changes in interest rates primarily on fixed-rate
mortgage loans which it has purchased or has committed to purchase. These
agreements generally have terms of not more than 90 days. Gains and losses on
such contracts are deferred as an adjustment of the carrying value of the
related mortgage loans.
Allowance for Possible Losses
The Company provides for possible losses at a level believed adequate by
management to absorb possible losses due to (i) mortgagor default on uninsured
mortgage loans, (ii) fraud in the origination of loans, (iii) special hazards on
pools of loans not covered by a special hazard insurance policy, and (iv) higher
than anticipated prepayments on other mortgage securities. The Company
continues to provide for losses in amounts it believes are commensurate with
purchases of mortgage loans and mortgage securities; the level of delinquencies,
foreclosures, fraud and special hazards expected to be experienced by the
Company; and expected prepayment performance of its investments in other
mortgage securities. The Company does not provide for losses resulting from
defaults on investments with guarantees from government sponsored entities or
with mortgage pool insurance (see Note G).
Purchased Mortgage Servicing Rights
In connection with the acquisition of mortgage loans, the Company may also
acquire the related servicing rights. The portion of the purchase price that
represents the cost of acquiring the servicing rights is capitalized as
purchased mortgage servicing rights. In addition, in connection with
securitization activities, the Company generally creates an excess servicing fee
receivable, the discounted present value of which is capitalized as master
servicing rights and is included in purchased mortgage servicing rights.
Amortization of purchased mortgage servicing rights and master servicing rights
is recorded in proportion to, and over the period of, estimated future net
servicing income or the excess servicing income stream.
29
Cash and Cash Equivalents
Cash and cash equivalents include cash on hand and highly liquid investments
with original maturities of three months or less. The carrying amount of cash
and cash equivalents approximates their fair value.
Borrowings
Collateralized mortgage securities and repurchase arrangements are carried at
their unpaid principal balances, net of unamortized discount or premium. Any
discount or premium is recognized as an adjustment to interest expense by the
interest method over the expected term of the related borrowings.
The fair value of collateralized mortgage securities is dependent upon the
characteristics of the mortgage securities collateral pledged to secure the
issuance. Therefore, fair value is based on the same method used for
determining fair value for the underlying mortgage securities collateral,
adjusted for credit enhancements. The carrying amount of borrowings under
repurchase arrangements approximates fair value.
Mortgage Servicing Revenues
Mortgage servicing revenues represent fees received for servicing and master
servicing loans. Servicing fees are calculated on the basis of the outstanding
monthly principal balance of loans serviced and are recognized as income when
collected. Master servicing fees are calculated in the same fashion and are
recognized as income when earned.
Income Taxes
Capstead and its qualified real estate investment trust ("REIT") subsidiaries
have elected to be taxed as a REIT and intend to continue to do so. As a result
of this election, Capstead is not taxed on taxable income distributed to
stockholders, provided that certain REIT qualification tests are met.
Currently, it is Capstead's policy to distribute 100 percent of taxable income
within the time limits prescribed by the Internal Revenue Code (the "Code"),
which may extend into the subsequent taxable year. Accordingly, no provision
has been made for income taxes for Capstead and its qualified REIT subsidiaries.
Net income for financial reporting purposes of Capstead and its qualified REIT
subsidiaries is lower than taxable income for the years presented. This
difference primarily results from the timing of the recognition of
collateralized mortgage security discounts, the provision for losses and the
write-down of certain investments. These items will reverse in future years
resulting in higher net income for financial reporting purposes than for federal
income tax purposes.
30
Certain of the Capstead's subsidiaries (the "non-REIT" subsidiaries) are
consolidated for financial reporting purposes, but are not consolidated for
federal and state income tax purposes. Because the non-REIT subsidiaries were
only recently incorporated, the January 1, 1993 adoption of the liability method
of accounting for income taxes as prescribed by Statement of Financial
Accounting Standards ("SFAS") No. 109 "Accounting for Income Taxes" had no
cumulative effect on the Company's consolidated financial statements. As of
December 31, 1993, the non-REIT subsidiaries had deferred tax liabilities of
approximately $300,000 that were offset by deferred tax assets totaling
approximately $675,000. A valuation allowance has been recorded against the
remaining deferred tax assets.
Net Income per Share
Primary net income per share is computed by dividing net income, after deduction
of preferred stock dividends, by the weighted average number of common shares
and common stock equivalents outstanding during the year.
Fully diluted net income per share is computed by dividing net income, after
deducting dividends on the $1.26 Cumulative Convertible Preferred Stock, Series
B ("Series B Preferred Stock"), by the weighted average number of common shares
and common stock equivalents outstanding during the year, assuming conversion of
the $1.60 Cumulative Preferred Stock, Series A ("Series A Preferred Stock").
The Series B Preferred Stock is not considered convertible for purposes of
calculating fully diluted net income per share as it is currently antidilutive.
Reclassification
Upon becoming fully self-administered on October 1, 1993, personnel of the
former manager became employees of the Company (see Note K). For comparison
purposes, amounts paid to the manager during the past three years for
reimbursement of salaries and related costs, as well as general and
administrative expenses, have been reclassified with similar expenses incurred
directly by the Company. These amounts totaled $5,196,000, $5,077,000 and
$3,482,000 for the periods ended September 30, 1993, December 31, 1992 and
December 31, 1991, respectively. Certain other amounts for prior years have
also been reclassified to conform to the 1993 presentation.
Recent Accounting Pronouncements
In May 1993 the Financial Accounting Standards Board issued SFAS No. 115
"Accounting for Certain Investments in Debt and Equity Securities." The Company
will adopt SFAS No. 115 on a prospective basis effective January 1, 1994. The
adoption will not have a material impact on the Company.
31
NOTE C -- MORTGAGE INVESTMENTS
The components of the Company's mortgage investment portfolios and the related
weighted average effective interest rates during the years indicated, were as
follows (dollars in thousands):
As of Year Ended
December 31 December 31
----------------------- ----------------------
1993 1992 1993 1992
---------- ---------- ---------- ----------
Mortgage loan portfolio:
Fixed-rate mortgage loans $1,249,575 $ 293,883 7.42% 8.86%
Adjustable-rate mortgage
loans 331,758 221,467 6.21 6.03
5/25 mortgage loans 43,484 73,410 7.17 8.43
AAA-rated mortgage pass-through
securities portfolio:
Adjustable-rate mortgage
securities 571,651 964,028 5.76 6.47
5/25 mortgage securities 276,178 136,303 7.58 8.36
Agency securities portfolio 402,781 215,509 6.80 7.33
---------- ----------
$2,875,427 $1,904,600
========== ==========
A portion of the Company's mortgage investments consist of adjustable-rate
mortgage loans and 5/25 mortgage loans. Adjustable-rate mortgage loans have
rates of interest which either (i) adjust semiannually based on a specified
margin over the six-month London interbank offered rate ("LIBOR"), or (ii)
adjust annually based on a specified margin over one-year United States Treasury
Securities, after an initial fixed rate period of one, three, five, or ten years
after origination. The 5/25 mortgage loans have initial interest rates that
adjust one time, approximately five years following the origination of the
mortgage loan, based on a specified margin over the Federal National Mortgage
Association ("FNMA") yields for 30-year fixed-rate commitments at the time of
the adjustment. Mortgage loans typically have original maturities ranging from
15 to 30 years and are fully amortizing over their terms. The AAA-rated
mortgage pass-through securities ("Mortgage Pass-Throughs") portfolio consists
of adjustable-rate and 5/25 mortgage loans from the Company's mortgage loan
portfolio, which have been securitized and rated AAA by a nationally recognized
statistical rating organization ("Rating Agency"). Agency securities consist of
mortgage-backed securities issued by government-sponsored entities, either
Federal Home Loan Mortgage Corporation ("FHLMC"), FNMA or Government National
Mortgage Association ("GNMA").
As of December 31, 1993, the Company had outstanding for hedging purposes
forward sale agreements with an aggregate gross contract amount of $450 million
and had commitments for the purchase of mortgage loans of approximately
$472,662,000. All loans were held for investment at December 31, 1993. As of
December 31, 1993, the fair value of the Company's mortgage investments,
including forward sale agreements for hedging purposes and commitments for the
purchase of mortgage loans, was estimated at $3.3 billion.
32
NOTE D -- MORTGAGE SECURITIES COLLATERAL
Mortgage securities collateral consists of collateral pledged to secure
repayment of borrowings through collateralized mortgage securities and other
mortgage securities. All principal and interest on the collateral is remitted
directly to a collection account maintained by a trustee. The trustee is
responsible for reinvesting those funds in short-term investments. All
collections on the collateral and the reinvestment income earned thereon are
available for the payment of principal and interest on the collateralized
mortgage securities.
The components of mortgage securities collateral are summarized as follows (in
thousands):
December 31
-------------------------
1993 1992
---------- ----------
Mortgage collateral $3,721,257 $5,056,007
Short-term investments 195,458 170,097
Accrued interest receivable 26,953 38,255
---------- ----------
Total collateral 3,943,668 5,264,359
Unamortized premium (discount) 6,341 (4,620)
---------- ----------
Net collateral 3,950,009 5,259,739
Other mortgage securities 12,671 9,861
---------- ----------
$3,962,680 $5,269,600
========== ==========
Mortgage collateral consists of adjustable-rate, fixed-rate, and 5/25 mortgage
loans and agency securities. The weighted average effective interest rate for
all mortgage securities collateral was 8.38 percent and 9.32 percent during the
years ended December 31, 1993 and 1992, respectively. As of December 31, 1993,
the fair value of mortgage securities collateral was estimated at $4.1 billion.
NOTE E -- COLLATERALIZED MORTGAGE SECURITIES
Each collateralized mortgage securities issuance, (a "series"), consists of
various classes, of which substantially all are at a fixed rate of interest.
Interest is payable quarterly or monthly at specified rates for all classes.
Typically, principal payments on each series are made to each class in the order
of their stated maturities so that no payment of principal will be made on any
class until all classes having an earlier stated maturity have been paid in
full.
The components of collateralized mortgage securities and certain other
information are summarized as follows (dollars in thousands):
December 31
---------------------------
1993 1992
---------- ----------
Collateralized mortgage securities $3,857,303 $5,150,941
Accrued interest payable 45,362 59,789
---------- ----------
Total obligation 3,902,665 5,210,730
Less unamortized discount (11,531) (67,573)
---------- ----------
Net obligation $3,891,134 $5,143,157
========== ==========
Range of average interest rates 4.78% to 10.00% 5.04% to 10.00%
Range of stated maturities 2007 to 2023 2007 to 2023
Number of series 43 44
33
The maturity of each series of securities is directly affected by the rate of
principal prepayments on the related mortgage securities collateral. Each
series of securities is also subject to redemption at the Company's option
provided that certain requirements specified in the related indenture have been
met. As a result, the actual maturity of any series of securities is likely to
occur earlier than its stated maturity. Because of continued high prepayments
on mortgage securities collateral, the Company accelerated amortization of bond
discount on existing collateralized mortgage securities resulting in the
recognition of additional interest expense. The average effective interest rate
for all collateralized mortgage securities was 9.05 percent and 8.80 percent
during the years ended December 31, 1993 and 1992, respectively. As of December
31, 1993, the fair value of collateralized mortgage securities was estimated at
$4.0 billion.
NOTE F -- SHORT-TERM BORROWINGS
Short-term borrowings are primarily made under repurchase arrangements. At
December 31, 1993, the Company had approved credit limits of $2 billion with
investment banking firms to finance the mortgage loan portfolio. Interest rates
on borrowings under these facilities are based on overnight LIBOR rates.
The Company currently uses other repurchase arrangements as needed. As the
Company commits to the issuance of collateralized mortgage securities or
publicly offered, multi-class mortgage pass-through certificates ("MPCs"), the
Company may pledge the mortgage loans that are expected to secure the issuance
as collateral for a repurchase transaction with the managing underwriter of the
related issuance. The Company also enters into repurchase and dollar repurchase
arrangements with investment banking firms pursuant to which the Company pledges
Mortgage Pass-Throughs and agency securities. The terms and conditions of these
arrangements, including interest rates, are negotiated on a transaction-by-
transaction basis.
Repurchase arrangements outstanding, which had maturities of less than 31 days,
were as follows (dollars in thousands):
December 31, 1993
------------------------------------------------
Collateral Borrowings
---------------------- -----------------------
Weighted
Carrying Market Amount Average
Value Value Outstanding Rate
---------- ---------- ---------- ----------
Mortgage loans $1,282,814 $1,284,780 $1,220,094 4.07%
Mortgage Pass-Throughs 847,829 856,841 824,682 3.62
Agency securities 402,781 396,390 399,031 3.38
---------- ---------- ----------
$2,533,424 $2,538,011 $2,443,807
========== ========== ==========
34
December 31, 1992
-----------------------------------------------
Collateral Borrowings
---------------------- -----------------------
Weighted
Carrying Market Amount Average
Value Value Outstanding Rate
---------- ---------- ----------- ---------
Mortgage loans $ 201,449 $ 199,199 $ 184,374 4.33%
Mortgage Pass-Throughs 1,100,331 1,115,072 1,050,795 4.14
Agency securities 215,509 217,711 214,040 3.75
---------- ---------- ----------
$1,517,289 $1,531,982 $1,449,209
========== ========== ==========
Accrued interest on short-term borrowings totaled $2,285,000 at December 31,
1993. The weighted average effective interest rate on all short-term borrowings
was 3.40 percent and 4.43 percent during 1993 and 1992, respectively.
NOTE G -- ALLOWANCE FOR POSSIBLE LOSSES
The Company has limited exposure to losses on mortgage loans. Losses due to
typical mortgagor default are substantially reduced by the acquisition of
mortgage pool insurance from AAA-rated mortgage pool insurers, which supplements
primary mortgage insurance, if any, and homeowner down payments. The amount of
coverage under any such mortgage pool insurance policy is the amount (typically
7 to 15 percent of the aggregate amount in such pool of mortgage loans)
determined by one or more Rating Agencies necessary to allow the related
securities to be rated AAA, when combined with homeowner down payments or other
insurance coverage. At December 31, 1993, the Company had default risk on
approximately $5,939,000 of its mortgage loans of which approximately $1,822,000
were delinquent 60 days or more. The remainder of mortgage assets were
considered to have no default risk because of guarantees from government
sponsored entities on agency securities or the acquisition of or commitment for
the issuance of mortgage pool insurance.
Certain other risks, however, are not covered by mortgage pool insurance and may
subject the Company to loss. These risks include fraud or misrepresentation
during origination of a mortgage loan and special hazards which are not covered
by standard hazard insurance policies (e.g. earthquakes). In cases of fraud the
Company generally will not be able to recover its losses from the mortgage
insurance company, but will generally have recourse to the prior owner of a loan
based on representations and warranties made at the time the loan was purchased.
However, to the extent the prior owner does not perform its repurchase
obligation, the Company may incur a loss. Special hazards are typically
catastrophic events that are unable to be predicted. In September 1991 the
Company began to limit its exposure to special hazard losses by acquiring
special hazard insurance coverage from a AAA-rated insurer. As of December 31,
1993, 69 percent of the Company's mortgage assets (excluding agency securities)
were covered by a special hazard insurance policy. Management does not believe
that fraud or special hazard risks pose a material threat to the operations of
the Company; however, the Company continually monitors its underwriting
guidelines and correspondents from which it purchases mortgage loans, as well as
the geographic concentration of the its mortgage assets, for possible changes in
the level of risk.
35
As of December 31, 1993, approximately 60 percent of the Company's mortgage
assets (excluding agency securities) were secured by properties located in
California. The Company's exposure arising from this geographic concentration
is reduced by the acquisition of mortgage pool insurance and special hazard
insurance (see Note M).
During 1993 and 1992 a portion of the Company's investment in other mortgage
securities was charged off due to diminishing cash flows resulting from
increased prepayments on the underlying collateral. Declines in mortgage
interest rates have made it increasingly advantageous for mortgagors whose
loans secure these investments to refinance. Management does not believe that
the risk of further impairment of these investments, which total $12,671,000 at
December 31, 1993, pose a material threat to the operations of the Company.
Activity in the allowance for possible losses was as follows (in thousands):
Year Ended December 31
----------------------
1993 1992
------- -------
Beginning balance $ 8,228 $ 3,505
Provision for possible losses 2,800 7,750
Charge-offs due to:
Mortgagor default (433) (515)
Fraud/misrepresentation (1,567) (616)
Special hazard losses (33) --
Impairment of other mortgage securities (2,068) (1,896)
------- -------
$ 6,927 $ 8,228
======= =======
NOTE H -- ACQUISITION
On December 2, 1992, the Company acquired the net assets of Tyler Cabot Mortgage
Securities Fund, Inc. ("Tyler Cabot"), a diversified closed-end management
investment company, in exchange for 29,429,815 shares of the Company's Series B
Preferred Stock. The acquisition has been accounted for as a purchase and,
accordingly, the assets and liabilities have been recorded based on their fair
value at the date of acquisition. The net income earned on the assets and
liabilities acquired have been included in the consolidated statement of income
from the date of the acquisition.
NOTE I -- STOCKHOLDERS' EQUITY
The Series A Preferred Stock issued in connection with a 1989 acquisition is
non-voting. Each share is entitled to a cumulative fixed dividend at an annual
rate of $1.60 and is eligible for conversion into 9/10 of 1 share of common
stock. The Series A Preferred Stock has a liquidation preference of $16.40 per
share and is redeemable at the Company's option, in whole or in part, at a
redemption price equal to the liquidation preference after November 6, 1994. At
December 31, 1993, 4,730,076 shares of the Series A Preferred Stock had been
converted to 4,257,005 shares of common stock.
The Series B Preferred Stock issued in connection with the acquisition of Tyler
Cabot is non-voting. Each share is entitled to a cumulative fixed dividend at
an annual rate of $1.26 and is eligible for conversion into 0.3196 of 1 share of
common stock. The Series B Preferred
36
Stock has a liquidation preference of $11.38 per share and is redeemable at the
Company's option, in whole or in part, at a redemption price of $12.50 after
December 2, 1997. At December 31, 1993, 13,580 shares of the Series B Preferred
Stock had been converted to 4,337 shares of common stock.
In February 1992 the Company received $61,643,000 in net proceeds from the
offering of 2,046,000 shares of common stock. Proceeds from the offering were
used to acquire mortgage assets.
During 1993 and 1992 the Company issued 10,362 and 17,408 shares of common stock
through its dividend reinvestment plan on which net proceeds of $395,000 and
$526,000 were received, respectively. During 1993 the Company also issued
381,473 shares of Series B Preferred Stock through its dividend reinvestment
plan for Series B stockholders on which net proceeds of $4,662,000 were
received.
On July 31, 1992, the Company issued a six-year option to Lomas Financial
Corporation ("LFC"), an affiliate of the former manager, for the purchase of
750,000 shares of common stock at a price of $32.63 per share. The option
becomes exercisable in 250,000 share increments through August 1, 1994.
The Company's Charter provides that if the Board of Directors determines in good
faith that the direct or indirect ownership of stock of Capstead has become
concentrated to an extent which would cause Capstead to fail to qualify as a
REIT, the Company may redeem or repurchase, at fair market value, any number of
shares of common stock and/or preferred stock sufficient to maintain or bring
such ownership into conformity with the Code and may refuse to transfer or issue
shares of common stock and/or preferred stock to any person whose acquisition
would result in Capstead being unable to comply with the requirements of the
Code. In addition, the Charter provides that the Company may redeem or refuse
to transfer any shares of capital stock of Capstead necessary to prevent the
imposition of a penalty tax as a result of ownership of such shares by certain
disqualified organizations, including governmental bodies and tax-exempt
entities that are not subject to tax on unrelated business taxable income.
NOTE J -- STOCK OPTION PLAN
The 1990 Directors' Stock Option Plan (the "Directors' Plan") and 1990 Employee
Stock Option Plan (the "Employee Plan") (together, the "Plans") provide for the
issuance of up to 160,000 and 240,000 shares, respectively, of common stock at a
price not less than the fair market value of the common stock at the time the
option is granted. The Plans also provide for dividend equivalent rights which
permit the option holder to obtain additional shares of common stock based upon
formulas set forth in the Plans.
37
Activity in the Plans is summarized as follows:
Directors' Plan Employee Plan
------------------------ ------------------------
Number Number
of Price of Price
Shares Range Shares Range
------- -------------- ------- --------------
Balance at inception of
Plan and
at January 1, 1991 60,000 $ 13.00 53,000 $ 13.00
Options granted -- -- 39,000 25.50
Options exercised (25,000) 13.00 (500) 13.00
------- -------
Balance at December 31, 1991 35,000 13.00 91,500 13.00 - 25.50
Options granted 6,000 29.38 39,000 34.50
Options exercised (5,114) 13.00 (27,619) 13.00
Dividend equivalent
rights earned 802 -- 1,205 --
------- -------
Balance at December 31, 1992 36,688 13.00 - 29.38 104,086 13.00 - 34.50
Options granted 22,000 39.13 - 39.25 44,000 38.88
Options exercised (11,663) 13.00 - 29.38 (46,637) 13.00 - 34.50
Dividend equivalent
rights earned 1,494 -- 2,646 --
------- -------
Balance at December 31, 1993 48,519 $13.00-$39.25 104,095 $13.00-$38.88
======= =======
In accordance with the terms of the Plans, on January 1, 1994 the Company
granted options to acquire 8,000 shares at an exercise price of $41 per share
under the Directors' Plan, and granted dividend equivalent rights for the
issuance of an additional 2,314 and 2,857 shares under the Directors' Plan and
Employee Plan, respectively. In addition, on January 24, 1994 the Company
granted options to a new member of the Board of Directors to acquire 5,000
shares at an exercise price of $40.63 per share.
NOTE K -- MANAGEMENT AND NON-COMPETITION AGREEMENTS
Since its inception and through September 30, 1993, the Company operated under a
management agreement with a subsidiary (the "Manager") of Lomas Mortgage USA,
Inc. ("LMUSA"). The agreement provided that the Manager advise the Company with
respect to all facets of its business and administer its day-to-day operations
under the supervision of the Board of Directors. The Manager paid, among other
things, salaries and benefits of its personnel, accounting fees and expenses,
other office expenses and expenses incurred in supervising and monitoring the
Company's investments. During the period from inception through July 31, 1992,
the Manager received management fees equal to specified percentages of the
Company's average invested assets and incentive fees equal to specified
percentages of amounts by which the return on common stockholders' equity
exceeded a specified return based on the average ten-year treasury yield.
On July 31, 1992, the Company entered into a 65-month management agreement with
the Manager with an effective date of August 1, 1992. Under the agreement, the
management fee was limited to an amount equal to the Manager's cost plus a fixed
profit aggregating $14,500,000 over the term of the agreement. Also on July 31,
1992, Capstead entered into a 65-month non-competition agreement with LFC, the
parent company of LMUSA, whereby LFC and its subsidiaries agreed to refrain from
engaging in the promotion, organization, operation or management of REITs, other
than Capstead, that invest primarily in jumbo mortgage loans in return for
payments aggregating $7 million.
38
In March and again in September 1993, the Company negotiated amendments to these
agreements to shorten their terms and lower the required payments by $1,972,000.
Consequently, on October 1, 1993 the Company became fully self-administered.
Termination costs under the terms of the amended management agreement totaled
$7,528,000. Also included in manager termination costs is $4,363,000 which
represents unamortized amounts paid under the non-competition agreement.
NOTE L -- TRANSACTIONS WITH AFFILIATES OF THE FORMER MANAGER
In connection with the acquisition of mortgage loans, the Company acquires
most of its loans on a servicing-released basis. On September 7, 1993, the
Company ceased its practice of simultaneously selling servicing rights
associated with these loans to LMUSA. Such sales were at a price comparable to
that which would be paid by unaffiliated third parties. Servicing rights
purchased by LMUSA totaled $16,512,000, $39,446,000 and $17,020,000 during
1993, 1992 and 1991, respectively. At December 31, 1993, LMUSA serviced
approximately 42 percent of the Company's mortgage assets excluding agency
securities. The mortgage loans are serviced in accordance with the terms of a
servicing agreement typical for the industry. Servicing fees of $19,029,000,
$12,978,000 and $3,834,000 were retained by LMUSA for the years ended December
31, 1993, 1992 and 1991, respectively.
Capstead purchased approximately $6,016,000, $20,195,000 and $4,440,000 of
mortgage loans from LMUSA in 1993, 1992 and 1991, respectively, at prices and
terms prevailing at the time of purchase.
NOTE M -- SUBSEQUENT EVENTS
Prior to December 31, 1993, the Company committed to issue three series of
collateralized mortgage securities and on January 11, 1994, committed to issue
one additional series. The series are scheduled to close in January or February
1994 with an aggregate issue balance of approximately $1.15 billion. These
issuances will be collateralized by mortgage loans from the Company's mortgage
loan portfolio. The Company will elect Real Estate Mortgage Investment Conduit
("REMIC") status for tax purposes on these issuances.
In addition, the Company has committed to bulk acquisitions of servicing rights
to service approximately $1.6 billion of mortgage loans. The Company will begin
servicing these loans between January and April of 1994.
On January 17, 1994, the Los Angeles region of southern California suffered a
relatively severe earthquake. The Company has exposure to earthquake losses in
cases where a homeowner defaults on his mortgage and the property has structural
damage from an earthquake, exclusive of fire or water damage (the standard
homeowners policy covers fire and water damage even if such damage was the
result of an earthquake). Although approximately $460 million of the Company's
mortgage assets are located in the affected areas (as determined by reference to
affected zip codes as reported by a rating agency), all but approximately $67
million of these assets are insured against such losses. At this point in time,
it is unclear how many of the underlying properties may have sustained damage
and, ultimately, if any loss will be incurred by the Company. The Company,
however, does not believe any such losses will be material.
39
NOTE N -- SUPPLEMENTAL CASH FLOW INFORMATION
The following table provides supplemental cash and noncash information (in
thousands):
Year Ended December 31
----------------------------------
1993 1992 1991
---------- ---------- ----------
Interest paid:
Short-term borrowings $ 81,722 $ 62,247 $ 29,479
Collateralized mortgage securities 375,948 323,346 139,584
Noncash investing and financing activities:
Transfers from mortgage investments to
mortgage securities collateral 1,197,947 3,603,844 1,484,947
Charges to allowance for possible losses 4,101 3,027 1,145
Acquisition of Tyler Cabot:
Net assets acquired -- 307,077 --
Net liabilities assumed -- 288 --
Preferred stock issued -- 315,025 --
NOTE O -- NET INTEREST INCOME ANALYSIS
The following table summarizes the amount of interest income and interest
expense and the average effective interest rate (dollars in thousands):
1993 1992 1991
------------------ ------------------- ------------------
Average Average Average
Amount Rate Amount Rate Amount Rate
-------- ------- -------- ------- -------- -------
Interest income:
Mortgage securities collateral $390,690 8.38% $383,060 9.32% $176,578 10.29%
Mortgage investments 184,136 6.56 117,527 7.49 58,989 9.38
-------- -------- --------
Total interest income 574,826 500,587 235,567
-------- -------- --------
Interest expense:
Collateralized mortgage securities 410,153 9.05 353,356 8.80 158,366 9.70
Short-term borrowings 80,923 3.40 62,077 4.43 31,474 6.38
-------- -------- --------
Total interest expense 491,076 415,433 189,840
-------- -------- --------
Net interest $ 83,750 $ 85,154 $ 45,727
======== ======== ========
The following table summarizes the amount of changes in interest income and
interest expense due to changes in interest rates versus changes in volume (in
thousands):
1993/1992* 1992/1991*
------------------------------- -------------------------------
Rate Volume Total Rate Volume Total
-------- --------- ------- -------- --------- --------
Interest income:
Mortgage securities collateral $(40,878) $ 48,508 $ 7,630 $(18,194) $ 224,676 $206,482
Mortgage investments (16,008) 82,617 66,609 (14,061) 72,599 58,538
-------- --------- ------- -------- --------- --------
(56,886) 131,125 74,239 (32,255) 297,275 265,020
-------- --------- ------- -------- --------- --------
Interest expense:
Collateralized mortgage securities 10,057 46,740 56,797 (13,140) 208,130 194,990
Short-term borrowings (16,887) 35,733 18,846 (12,091) 42,694 30,603
-------- --------- ------- -------- --------- --------
(6,830) 82,473 75,643 (25,231) 250,824 225,593
-------- --------- ------- -------- --------- --------
$(50,056) $ 48,652 $(1,404) $ (7,024) $ 46,451 $ 39,427
======== ========= ======= ======== ========= ========
*The change in interest due to both volume and rate has been allocated to volume
and rate changes in proportion to the relationship of the absolute dollar
amounts of the change in each.
40
NOTE P - QUARTERLY RESULTS (UNAUDITED)
The following is a summary of the unaudited quarterly results of operations (in
thousands, except per share amounts):
Year Ended December 31, 1993
---------------------------------------
First Second Third Fourth
Quarter Quarter Quarter Quarter
-------- -------- -------- --------
Interest income $149,566 $153,129 $149,683 $122,448
Interest and related expenses 127,756 130,861 125,466 129,877*
Net margin on mortgage assets 21,810 22,268 24,217 (7,429)
Other revenues 9,692 6,528 13,208 37,249
Net income 22,904 23,255 23,640 24,457
Net income per share:
Primary $ .88 $ .90 $ .92 $ .97
Fully diluted .86 .88 .90 .95
Year Ended December 31, 1992
---------------------------------------
First Second Third Fourth
Quarter Quarter Quarter Quarter
-------- -------- -------- --------
Interest income $100,791 $123,976 $133,329 $142,491
Interest and related expenses 87,433 107,485 117,081 125,005
Net margin on mortgage assets 13,358 16,491 16,248 17,486
Other revenues 1,112 (100) 1,095 1,755
Net income 11,207 12,553 13,234 16,197
Net income per share:
Primary $ .81 $ .83 $ .87 $ .87
Fully diluted .76 .80 .84 .84
* Because of high prepayments on mortgage securities collateral during the
fourth quarter, the Company accelerated amortization of bond discount on
existing collateralized mortgage securities resulting in the recognition of an
additional $28 million in interest expense.
NOTE Q -- MARKET AND DIVIDEND INFORMATION (UNAUDITED)
The New York Stock Exchange trading symbol for the Company's common stock is
CMO. There were approximately 2,600 holders of record of the Company's common
stock at December 20, 1993. In addition, depository companies held stock for
approximately 22,000 beneficial owners. During the last two years, the high and
low stock sales prices and dividends declared on common stock were as follows:
Year Ended December 31, 1993 Year Ended December 31, 1992
---------------------------- ----------------------------
Stock Prices Stock Prices
----------------- Dividends ----------------- Dividends
High Low Declared High Low Declared
------- ------- ---------- ------- ------- ---------
First quarter $42 7/8 $36 1/2 $.88 $35 1/4 $27 1/2 $.76
Second quarter 42 7/8 35 3/4 .90 34 1/4 28 3/4 .80
Third quarter 40 37 1/2 .92 36 7/8 31 7/8 .84
Fourth quarter 42 3/8 35 7/8 .96 39 3/8 33 1/8 .86
41
CAPSTEAD MORTGAGE CORPORATION AND SUBSIDIARIES
SELECTED FINANCIAL DATA
(IN THOUSANDS, EXCEPT PERCENTAGES AND PER SHARE AMOUNTS)
Year Ended December 31
------------------------------------------------------------
1993 1992 1991 1990 1989
---------- ---------- ---------- ---------- ----------
Selected consolidated statement of income data (1):
Interest income $ 574,826 $ 500,587 $ 235,567 $ 179,702 $ 131,965
Interest and related expenses 513,960 437,004 194,665 147,658 111,558
Net margin on mortgage assets 60,866 63,583 40,902 32,044 20,407
Other revenues 66,677 3,862 2,682 2,213 1,882
Net income 94,256 53,191 33,717 29,082 16,375
Net income per share:
Primary (2) $ 3.68 $ 3.37 $ 2.92 $ 2.34 $ 1.73
Fully diluted 3.57 3.23 2.46 2.14 1.73
Return on average total stockholders' equity 14.65% 16.08% 13.25% 11.50% 8.72%
Cash dividends paid per share:
Common $ 3.66 $ 3.26 $ 2.56 $ 2.27 $ 2.10
Series A Preferred 1.60 1.60 1.60 1.60 0.24
Series B Preferred 1.26 0.10 -- -- --
Average number of shares outstanding:
Primary 15,146 14,394 8,964 8,700 8,700
Fully diluted 15,930 15,591 13,683 13,619 9,451
Selected consolidated balance sheet data (at year end):
Mortgage investments $2,875,427 $1,904,600 $ 983,024 $ 257,537 $ 196,186
Mortgage securities collateral 3,962,680 5,269,600 2,806,616 1,570,427 1,526,036
Total assets 6,980,324 7,229,608 3,824,546 1,829,376 1,735,912
Short-term borrowings 2,443,807 1,449,209 855,572 108,248 64,826
Collateralized mortgage securities 3,891,134 5,143,157 2,708,630 1,466,508 1,416,614
Stockholders' equity 638,190 631,499 253,339 251,023 250,436
Other data:
Mortgage loans acquired during the year $4,393,273 $5,483,602 $2,171,362 $ 279,724 $ 334,439
Outstanding commitments to acquire mortgage
investments (at year end) 472,662 573,831 478,909 111,400 44,700
(1) On December 2, 1992 the Company acquired the common stock of Tyler Cabot
Mortgage Securities Fund, Inc. in exchange for 29,429,815 shares of the
Company's Series B Preferred Stock. The acquisition has been accounted for as a
purchase and the net income earned on the assets and liabilities acquired have
been included in the Consolidated Statement of Income from the date of the
acquisition. Additionally, on November 6, 1989 the Company acquired the common
stock of Strategic Mortgage Investments, Inc. in exchange for 5,465,000 shares
of the Company's Series A Preferred Stock. The acquisition was accounted for as
a purchase and the operating results of Strategic have been included in the
Consolidated Statement of Income from the date of acquisition.
(2) During the years ended December 31, 1992 and 1991, 1,382,551 and 3,140,304
shares of the Series A Preferred Stock were converted into 1,244,261 and
2,826,256 shares of common stock, respectively. If these conversions had
occurred at the beginning of the respective years, primary net income per share
would have been $3.32 and $2.60 per share for the years ended December 31,
1992 and 1991, respectively.
42
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
FINANCIAL CONDITION
During the year ended December 31, 1993, the Company purchased 14,089 mortgage
loans totaling $4,393,273,000, compared to purchases of 17,063 mortgage loans
totaling $5,483,602,000 during 1992. Purchase and commitment volumes remained
high during 1993 compared to historical levels primarily due to a generally
favorable interest rate environment.
During 1993 the Company was able to expand its correspondent network resulting
in less reliance on the economically depressed California market. During 1993,
44 percent of the Company's mortgage loan acquisitions were secured by
properties located in California, down from 75 percent in 1992. As of December
31, 1993, approximately 60 percent of the Company's mortgage assets were secured
by properties located in California, compared to 77 percent as of December 31,
1992. Although the Company continues to expand its marketing efforts to acquire
mortgage loans from other regions of the United States, California is the
largest market for jumbo mortgage loans; therefore, no assurance can be given
that the Company's operations would not be materially affected by economic or
other events in California.
On January 17, 1994, the Los Angeles region of southern California suffered a
relatively severe earthquake. The Company has exposure to earthquake losses in
cases where a homeowner defaults on his mortgage and the property has structural
damage from an earthquake, exclusive of fire or water damage (the standard
homeowners policy covers fire and water damage even if such damage was the
result of an earthquake). Although approximately $460 million of the Company's
mortgage assets are located in the affected areas (as determined by reference to
affected zip codes as reported by a rating agency), all but approximately $67
million of these assets are insured against such losses. At this point in time,
it is unclear how many of the underlying properties may have sustained damage
and, ultimately, if any loss will be incurred by the Company. The Company,
however, does not believe any such losses will be material. Indications are that
like the 1989 San Francisco earthquake, most of the damage was sustained by
infrastructure (i.e., water and gas mains, roads and bridges). Additionally,
according to an industry source, an estimated 25 percent of homeowners in
California carry earthquake insurance. Other considerations include homeowner
equity and the availability of low-cost loans from the government for repairs.
Finally, and perhaps most significantly, in costly areas such as southern
California, land can represent over 50 percent of the value of a home.
The Company formed $1 billion of AAA-rated private mortgage pass-through
securities ("Mortgage Pass-Throughs") during the year ended December 31, 1993,
the majority of which were backed by adjustable-rate mortgage loans ("ARM"
loans). The primary benefit
43
of pooling mortgage loans into Mortgage Pass-Throughs is the liquidity of AAA-
rated securities over that of individual loans. As a result, when securing
short-term borrowings, the Company is able to negotiate more favorable terms.
Over the past several years the Company has followed a strategy of building a
large portfolio of Mortgage Pass-Throughs. During 1993 an industry-wide
reduction in the number of ARM loan originations resulted in a shortage of ARM
loans in the market, thereby enabling the Company to realize substantial gains
from the sale of $1.1 billion of this portfolio. The Company plans to continue
to retain a large portfolio of Mortgage Pass-Throughs.
During the year ended December 31, 1993, the Company's collateralized mortgage
obligation ("CMO") investment portfolio declined from $126,443,000 to
$71,546,000, as record levels of prepayments on mortgage securities collateral
dramatically reduced outstanding balances of existing CMOs. Additionally, in a
modification of its previous investment strategy, the Company sold a portion of
its fixed-rate mortgage loans in 1993, primarily by issuing publicly-offered,
multi-class mortgage pass-through certificates ("MPCs"). During 1993 the Company
issued nine MPCs through special-purpose finance subsidiaries totaling $2.2
billion (including the sales of Mortgage Pass-Throughs mentioned above) and sold
$211 million of whole loans, retaining investments totaling $11,045,000
(primarily interest-only and principal-only bonds). The Company also issued
seven CMOs totaling $1.2 billion through special-purpose finance subsidiaries
secured by mortgage loans or agency securities. The Company's net investment in
these financings at issuance totaled $7,661,000.
The following table summarizes the Company's utilization of capital as of
December 31, 1993 (in thousands):
Funded Through
-------------------------
Assets Borrowings Equity
---------- ---------- --------
Mortgage loan portfolio:
Fixed-rate mortgage loans $1,249,575 $ 965,102 $284,473
Adjustable-rate mortgage loans 331,758 222,619 109,139
5/25 mortgage loans 43,484 32,373 11,111
Mortgage Pass-Through portfolio:
Adjustable-rate mortgage securities 571,651 554,834 16,817
5/25 mortgage securities 276,178 269,848 6,330
Agency securities portfolio 402,781 399,031 3,750
CMO investment portfolio 3,962,680 3,891,134 71,546
---------- ---------- --------
$6,838,107 $6,334,941 503,166
========== ========== ========
Other assets, net of other liabilities
(and including $29 million of
purchased mortgage servicing rights
and master servicing rights) 135,024
--------
Total stockholders' equity $638,190
========
As of December 31, 1993, the Company's mortgage investments and its commitments
to acquire mortgage loans ("Pipeline") totaled approximately $3.35 billion.
Market value risk associated with holding or acquiring these assets was reduced
by pricing three CMOs totaling approximately $950 million prior to year-end and
entering into forward sale agreements for
44
hedging purposes totaling $450 million. In addition, approximately $1.0 billion
was invested or committed for investment in ARM loans, which generally tend to
hold their market value in a rising interest rate environment. Remaining
mortgage assets and Pipeline (adjusted for historical Pipeline fallout of 30
percent on "best efforts" commitments) that was subject to market value risk as
of December 31, 1993 was approximately $800 million. As the Company continues to
acquire mortgage loans, it may pool such loans into CMOs or MPCs, thereby
periodically reducing the amount of mortgage loans subject to market value risk
(see "Effects of Interest Rate Changes").
The Company formed its mortgage servicing unit early in 1993, and as of December
31, 1993, serviced and master serviced mortgage loan portfolios of $2.4 billion
and $4.4 billion, respectively. This growth was accomplished primarily by
retaining servicing rights on mortgage loans purchased during the year and
master servicing rights on mortgage loans placed into securitizations during the
year. Federal National Mortgage Association and Federal Home Loan Mortgage
Corporation servicing approvals have been obtained so that the Company can
service conforming loans guaranteed by these government sponsored entities and
the Company has committed to bulk acquisitions of servicing rights for both
conforming and non-conforming mortgage loan portfolios totaling $1.6 billion to
be completed in early 1994.
In February 1992 the Company received $61.6 million in net proceeds from an
offering of 2,046,000 shares of common stock. In December 1992 the Company
issued 29,429,815 shares of $1.26 Cumulative Convertible Preferred Stock, Series
B, ("Series B Preferred Stock") valued at $315 million, in connection with the
acquisition of Tyler Cabot Mortgage Securities Fund, Inc. During 1993 the
Company received $6,248,000 of additional capital through its common stock and
Series B Preferred Stock dividend reinvestment plans, and through stock option
exercises. After payment of a record $93.8 million in common and preferred stock
dividends, stockholders' equity stood at over $638 million at December 31, 1993,
making Capstead one of the most strongly capitalized mortgage banking companies
in America.
RESULTS OF OPERATIONS
1993 Compared to 1992
Net income for the year ended December 31, 1993 was $94,256,000, or $3.68 per
primary share ($3.57 per fully diluted share), which represents a return on
average total stockholders' equity of 14.65 percent. This compares to 1992 net
income of $53,191,000, or $3.37 per primary share ($3.23 per fully diluted
share), which represents a return on average total stockholders' equity of 16.08
percent.
An important factor in producing higher operating results in 1993 was the
issuance of $315 million of Series B Preferred Stock in December 1992, which
doubled the Company's capital and earnings potential. Throughout most of 1993,
the Company maintained larger mortgage investment portfolios as the Company
sought to deploy this additional capital in a favorable interest rate
environment. Lower short-term borrowing rates further increased these
portfolios' contributions to net income. Finally, gains from securitizations and
other asset sales contributed to the increase in net income. Because of higher
contributions to
45
income from these sources, losses sustained by the CMO investment portfolio
and costs associated with terminating the Company's relationship with the former
manager did not disrupt the Company's trend of continued earnings growth.
The following table presents the components and weighted average yields of the
Company's mortgage investment portfolios, and related short-term borrowings:
Year Ended December 31
----------------------
1993 1992
------ ------
Mortgage loans 7.07% 8.06%
Mortgage Pass-Throughs 6.07 6.93
Agency securities 6.80 7.33
Short-term borrowings 3.40 4.43
Interest income earned on the Company's mortgage investments increased for the
year ended December 31, 1993 because of an increase in the average portfolios
outstanding, net of the effects of decreases in mortgage interest rates. The
combined average mortgage investment portfolio increased to $2,805,709,000 for
the year ended December 31, 1993, from $1,569,131,000 in 1992. The increase
reflects the continued growth in the underlying mortgage loan and Mortgage Pass-
Through portfolios because of continued high volume of loan purchases during the
year and the timing of securitizations. The Company also maintained a larger
position in agency securities due primarily to opportunities to earn superior
interest rate spreads with dollar repurchase agreements. The lower yields on
these portfolios reflects the general reduction in interest rates on all types
of mortgage products.
Short-term borrowing costs for the year ended December 31, 1993 were higher than
those experienced during 1992 because of a $1 billion increase in the average
debt outstanding to $2,338,796,000, primarily due to growth of the related
portfolios, net of the effect of decreases in short-term interest rates. The
weighted average interest rate on short-term borrowings declined 103 basis
points for the year ended December 31, 1993, due to declines in short-term
interest rates over the last two years and use of dollar repurchase agreements
to finance the agency securities portfolio.
The following table presents the weighted average yields of the mortgage
securities collateral and collateralized mortgage securities components of the
CMO investment portfolio :
Year Ended December 31
----------------------
1993 1992
------- ------
Mortgage securities collateral 8.38% 9.32%
Collateralized mortgage securities 9.05 8.80
------- -----
Net interest spread (0.67)% 0.52%
======= =====
The CMO investment portfolio experienced a net loss of $34,560,000 during the
year ended December 31, 1993, compared to net income of $18,420,000 in 1992.
Operating results produced by the CMO investment portfolio is represented by
interest income on mortgage securities collateral less interest expense and
professional fees on collateralized mortgage
46
securities, and mortgage pool insurance expense on mortgage securities
collateral, and includes net investment income or loss on other mortgage
securities held by the Company.
Operating results produced by the CMO investment portfolio decreased primarily
because of high levels of prepayments on mortgage securities collateral. During
1993 the Company received principal collections on mortgage securities
collateral totaling $2.4 billion, nearly double the $1.3 billion of runoff in
1992. Due to these high levels of prepayments, and the expectation that high
prepayments may continue, it became apparent late in the year that it was
unlikely that remaining mortgage securities collateral would be outstanding long
enough to recover unamortized bond discounts as previously expected.
Consequently, an additional $28 million in discount was amortized to bring total
amortization to $48,631,000 in 1993, up from $16,933,000 in 1992.
During 1993 the Company sold mortgage assets totaling $3.9 billion recognizing a
net gain of $61.2 million. Included in the sales were $1.1 billion of ARM loans
from the Mortgage Pass-Through portfolio on which gains of $35 million were
recognized.
Mortgage insurance expense increased during the year due primarily to a $1.0
billion increase in the average balance of insured mortgage loans from 1992 to
1993.
In March and again in September 1993, the Company negotiated amendments to its
management agreement and a related non-competition agreement, principally to
shorten the agreements' terms and lower the required payments by $1,972,000.
Consequently, on October 1, 1993 the Company became fully self-administered.
Termination costs under the terms of the amended management agreement totaled
$7,528,000. Also included in manager termination costs is $4,363,000, which
represents unamortized amounts paid under the non-competition agreement.
The Company provided $2,800,000 for possible losses during the year ended
December 31, 1993, compared to $7,750,000 in 1992. Lower purchase volume and
more stringent underwriting guidelines contributed to lower provision
requirements.
1992 Compared to 1991
Net income for the year ended December 31, 1992 was $53,191,000, or $3.37 per
primary share ($3.23 per fully diluted share), which represents a return on
average total stockholders' equity of 16.08 percent. This compares to 1991 net
income of $33,717,000, or $2.92 per primary share ($2.46 per fully diluted
share), which represents a return on average total stockholders' equity of 13.25
percent.
The increase in net income in 1992 resulted primarily from increased mortgage
loan acquisitions, lower short-term borrowing rates and additions to capital of
$62 million in February and $315 million in December. Mortgage loan acquisitions
were $5.5 billion in 1992, compared to $2.2 billion in 1991 primarily due to a
favorable interest rate environment, which in addition to stimulating demand for
mortgage loan originations, contributed to lower short-term borrowing rates.
Borrowing rates were also favorably impacted by
47
utilization of less expensive short-term financing vehicles, namely, repurchase
arrangements secured by mortgage loans and Mortgage Pass-Throughs.
Interest income on the Company's mortgage investments increased for the year
ended December 31, 1992 because of a $941 million increase in the combined
average portfolios outstanding, as a result of increased mortgage loan
acquisitions and the Company's decision to increase the size of the Mortgage
Pass-Through portfolio. Yields on the Company's mortgage investments declined
190 basis points to 7.49 percent during 1992. Lower yields reflect a general
reduction in interest rates on all types of mortgage products and an increase in
the amount of adjustable-rate mortgage loans held in the Mortgage Pass-Through
portfolio. Short-term borrowing costs for the year ended December 31, 1992 were
higher than those experienced during 1991 primarily because of an $890 million
increase in the average debt outstanding, net of the effects of 195 basis point
decrease in short-term interest rates to 4.43 percent during 1992.
Net income produced from the CMO Investment portfolio increased $2,754,000 to
$18,420,000 for the year ended December 31, 1992. The increase is due primarily
to a $22,362,000 increase in the average CMO investment portfolio to
$115,046,000 for the year ended December 31, 1992, as a result of issuing 20
CMOs offset by a seven basis point decline in the net interest spread between
the mortgage securities collateral and related bonds due primarily to increased
prepayments on several previously issued CMOs.
On July 31, 1992, the Company entered into a 65-month management agreement with
an effective date of August 1, 1992. Under this agreement, the management fee
was limited to an amount equal to the manager's cost plus a fixed profit
aggregating $14,500,000 over the term of the agreement.
Mortgage insurance expense increased during the year due primarily to a $3.0
billion increase in the average balance of insured mortgage loans from 1991 to
1992.
The Company provided $7,750,000 for possible losses during the year ended
December 31, 1992, compared to $1,707,000 in 1991. The substantial increase in
purchase volume and a rise in delinquencies and foreclosures attributed to a
general slowdown in the California economy contributed to higher provision
requirements.
LIQUIDITY AND CAPITAL RESOURCES
The Company's primary sources of funds include monthly mortgage loan principal
and interest payments, short-term financing arrangements, excess cash flows on
issued CMOs, proceeds from securitizations, and equity offerings when available.
The Company currently believes that these funds are sufficient for the
acquisition of additional mortgage loans and other mortgage assets, repayments
on short-term borrowings, growth of its servicing unit and the payment of cash
dividends as required for Capstead's continued qualification as a Real Estate
Investment Trust ("REIT"). It is the Company's policy to remain strongly
capitalized and conservatively leveraged.
48
In a modification to its previous investment strategy, the Company may, from
time to time, sell a portion of its fixed-rate mortgage loans and its
investments in other mortgage loans, by issuing MPCs and electing Real Estate
Mortgage Investment Conduit ("REMIC") status for tax purposes on these
transactions. Such sales may make quarterly income more volatile than in the
past because of the recognition of transactional gains or losses.
Short-term borrowings are primarily made under repurchase arrangements. At
December 31, 1993, the Company had uncommitted repurchase facilities with
investment banking firms with approved credit limits of $2 billion, subject to
certain conditions, to finance the mortgage loan portfolio. Interest rates on
borrowings under these facilities are based on overnight London interbank
offered rate ("LIBOR") rates. The Company currently uses other repurchase
arrangements as needed. As the Company commits to the issuance of CMOs or MPCs,
the Company may deliver the mortgage loans that are expected to secure the
issuance as collateral for a repurchase transaction with the managing
underwriter of the related issuance. The Company also enters into repurchase and
dollar repurchase arrangements with investment banking firms pursuant to which
the Company pledges Mortgage Pass-Throughs and agency securities. The terms and
conditions of these arrangements, including interest rates, are negotiated on a
transaction-by-transaction basis.
EFFECTS OF INTEREST RATE CHANGES
Changes in interest rates may impact the Company's earnings in various ways. The
Company's earnings depend, in part, on the difference between the interest
received on mortgage investments and the interest paid on related short-term
borrowings (primarily repurchase arrangements). The resulting spread may be
reduced in a rising interest rate environment. For ARM loans the risk of rising
short-term interest rates is offset to some extent by increases in the rates of
interest earned on these loans. Since ARM loans generally limit the amount of
such increase during any single interest rate adjustment period and over the
life of the loan, it is possible that the interest rates on the repurchase
arrangements could rise to levels that may exceed the interest rates on the
underlying ARM loans which may cause the Company to realize a negative interest
spread.
In addition, the Company's earnings are impacted if long-term interest rates
change during the period after the Company has committed to purchase fixed-rate
mortgage loans, but before these loans have been pledged to secure CMOs or MPCs.
If long-term interest rates increase during this period, the interest payable on
the CMOs issued will increase, while the yield on the underlying mortgage loans
pledged to collateralize the CMOs will not change; as a consequence, the
interest spread on the CMO will be lower. Conversely, if long-term interest
rates decrease during this period, the interest payable on the CMO issued will
decrease, while the yield on the underlying mortgage loans pledged to
collateralize the CMO will not change; as a consequence, the interest spread on
the CMO will be higher. Similarly, proceeds received on the issuance of MPCs,
and related gains or losses, will be negatively impacted by an increase in long-
term interest rates during this period due to the resulting
49
decline in market value of the related collateral. Conversely, these
transactional gains or losses will be favorably impacted by a decrease in long-
term interest rates during this period. The Company attempts to manage its
exposure to long-term interest rate changes in part by pricing CMOs and MPCs
prior to the purchase of, but subsequent to the commitment to purchase, all of
the mortgages that will collateralize the issuance, and may from time to time
elect to enter into forward sale agreements for hedging purposes.
A change in interest rates also impacts earnings recognized from the Company's
CMO investment portfolio, which consists primarily of fixed-rate CMO residuals.
The amount of income that may be generated from the typical CMO residual is
dependent upon the rate of principal prepayments on the underlying mortgage
loans. If mortgage interest rates fall significantly below the interest rate on
the collateral pledged to secure the CMO, principal prepayments will increase,
reducing or even eliminating the overall return on the investment in the CMO
residual. This is due primarily to the acceleration of the amortization of bond
discounts, a noncash item, as bond classes are repaid more rapidly than
originally anticipated. During 1993 the Company experienced such a period of
declining rates and high prepayments and having concluded that high levels of
prepayments may continue, has reduced its remaining bond discounts accordingly.
Another effect of changes in interest rates is that if interest rates decrease,
the rate of prepayment of mortgage loans may increase. To the extent the
proceeds of prepayments of mortgage loans or agency securities in the Company's
mortgage investment portfolios cannot be reinvested at a rate of interest at
least equal to the rate previously earned on such mortgage loans or agency
securities, the Company's earnings may be adversely affected. In addition, the
rates of interest earned on the Company's ARM loans generally will decline
during periods of falling interest rates.
The above discussion regarding how changes in interest rates impact our
investments in mortgage loans and other mortgage assets also applies to our
growing investment in purchased mortgage servicing rights and master servicing
rights. If interest rates rise, our servicing and master servicing assets become
more valuable since the average lives of the related mortgage loans will tend to
be longer and earnings from large, temporarily-held cash balances will be
greater. Conversely, lower interest rates will spur prepayments thus reducing
the period of time we can service the related loans. Because the Company began
servicing in 1993, exposure to lower interest rates is less than for other
servicers that acquired servicing portfolios in previous years when interest
rates were substantially higher.
RECENT ACCOUNTING PRONOUNCEMENTS
In May 1993 the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards ("SFAS") No. 115 "Accounting for Certain
Investments in Debt and Equity Securities." The Company will adopt SFAS No. 115
on a prospective basis effective January 1, 1994. The adoption will not have a
material impact on the Company.
50