1
EXHIBIT 13
CAPSTEAD MORTGAGE CORPORATION
PORTIONS OF THE
ANNUAL REPORT TO STOCKHOLDERS
FOR THE YEAR ENDED DECEMBER 31, 2000
2
REPORT OF INDEPENDENT AUDITORS
Stockholders and Board of Directors
Capstead Mortgage Corporation
We have audited the accompanying consolidated balance sheets of Capstead
Mortgage Corporation as of December 31, 2000 and 1999, and the related
consolidated statements of operations, stockholders' equity and preferred stock
subject to repurchase, and cash flows for each of the three years in the period
ended December 31, 2000. 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 auditing standards generally
accepted in the United States. 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 financial statements referred to above present fairly,
in all material respects, the consolidated financial position of Capstead
Mortgage Corporation at December 31, 2000 and 1999, and the consolidated results
of their operations and their cash flows for each of the three years in the
period ended December 31, 2000, in conformity with accounting principles
generally accepted in the United States.
/S/ ERNST & YOUNG LLP
Dallas, Texas
January 30, 2001, except for
NOTES 11 and 13 as to which
the date is February 16, 2001 and
February 20, 2001, respectively
3
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
YEAR ENDED DECEMBER 31
---------------------------------
2000 1999 1998
- -------------------------------------------------------------------------------------------------
INTEREST INCOME:
Mortgage securities and other investments $349,533 $293,841 $ 311,807
CMO collateral and investments 237,052 269,318 355,391
-------- -------- ---------
Total interest income 586,585 563,159 667,198
-------- -------- ---------
INTEREST AND RELATED EXPENSE:
Borrowings under repurchase arrangements 303,126 232,852 313,858
CMO borrowings 237,479 270,081 340,248
Mortgage insurance and other 1,545 2,014 5,469
-------- -------- ---------
Total interest and related expense 542,150 504,947 659,575
-------- -------- ---------
Net margin on mortgage assets and other investments 44,435 58,212 7,623
-------- -------- ---------
NET MARGIN ON MORTGAGE BANKING OPERATIONS - - 11,821
-------- -------- ---------
OTHER REVENUE (EXPENSE):
Gain (loss) on sale of mortgage assets and related
derivative financial instruments (70,173) 1,738 (245,261)
Impairment on mortgage assets (19,088) - (4,051)
Severance costs (3,607) - -
CMO administration and other 3,484 4,083 4,598
Other operating expense (6,537) (6,124) (9,494)
-------- -------- ---------
Total other revenue (expense) (95,921) (303) (254,208)
-------- -------- ---------
NET INCOME (LOSS) $ (51,486) $ 57,909 $(234,764)
========= ======== =========
Net income (loss) $ (51,486) $ 57,909 $(234,764)
Less preferred share dividends (24,260) (22,556) (22,342)
-------- -------- ---------
Net income (loss) available to common stockholders $ (75,746) $ 35,353 $(257,106)
========= ======== =========
Basic and diluted net income (loss) per common share $(3.30) $1.21 $(8.44)
See accompanying notes to consolidated financial statements.
4
CONSOLIDATED BALANCE SHEETS
(In thousands, except per share amounts)
DECEMBER 31
-------------------------
2000 1999
- -----------------------------------------------------------------------------------------------
ASSETS
Mortgage securities and other investments
($5.1 billion pledged under repurchase arrangements) $5,394,459 $5,408,714
CMO collateral and investments 3,126,878 3,318,886
---------- -----------
8,521,337 8,727,600
Prepaids, receivables and other 67,399 50,951
Cash and cash equivalents 21,761 28,488
---------- -----------
$8,610,497 $8,807,039
========== ==========
LIABILITIES
Borrowings under repurchase arrangements $4,904,632 $4,872,392
Collateralized mortgage obligations ("CMOs") 3,103,874 3,289,584
Accounts payable and accrued expenses 31,112 30,673
---------- -----------
8,039,618 8,192,649
---------- -----------
PREFERRED STOCK SUBJECT TO REPURCHASE
$0.10 par value; 5,378 and 10,756 shares authorized, issued
and outstanding at December 31, 2000 and 1999,
respectively ($25,599 aggregate repurchase amount) 25,210 50,584
---------- -----------
STOCKHOLDERS' EQUITY
Preferred stock - $0.10 par value; 94,622 shares authorized:
$1.60 Cumulative Preferred Stock, Series A,
374 shares issued and outstanding at
both December 31, 2000 and 1999
($6,134 aggregate liquidation preference) 5,228 5,228
$1.26 Cumulative Convertible Preferred Stock, Series B,
15,845 and 16,673 shares issued and outstanding at
December 31, 2000 and 1999, respectively
($180,316 aggregate liquidation preference) 177,012 186,248
Common stock - $0.01 par value; 100,000 shares authorized;
25,282 and 28,428 shares issued and outstanding at
December 31, 2000 and 1999, respectively 253 284
Paid-in capital 740,613 769,902
Accumulated deficit (396,882) (304,568)
Accumulated other comprehensive income (loss) 19,445 (93,288)
---------- -----------
545,669 563,806
---------- -----------
$8,610,497 $8,807,039
========== ==========
See accompanying notes to consolidated financial statements.
5
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND
PREFERRED STOCK SUBJECT TO REPURCHASE
(In thousands, except per share amounts)
THREE YEARS ENDED DECEMBER 31, 2000
---------------------------------------------------------------------------------
PREFERRED ACCUMULATED
STOCK OTHER TOTAL
SUBJECT TO PREFERRED COMMON PAID-IN ACCUMULATED COMPREHENSIVE STOCKHOLDERS'
REPURCHASE STOCK STOCK CAPITAL DEFICIT INCOME (LOSS) EQUITY
- ------------------------------------------------------------ ---------------------------------------------------------------------
BALANCE AT JANUARY 1, 1998 $ - $195,498 $292 $732,588 $ 12,676 $(52,446) $ 888,608
Comprehensive loss:
Net loss - - - - (234,764) - (234,764)
Other comprehensive income (loss):
Change in unrealized loss on debt
securities, net of reclassification
amount - - - - - 51,228 51,228
---------
Total comprehensive loss (183,536)
Cash dividends:
Common ($2.00 per share) - - - - (60,857) - (60,857)
Preferred - - - - (22,342) - (22,342)
Conversion of preferred stock - (1,111) - 1,111 - - -
Additions to capital - 4,037 15 58,380 - - 62,432
Capital stock repurchases - - (5) (4,099) - - (4,104)
-------- -------- ---- ------- --------- ------- ---------
BALANCE AT DECEMBER 31, 1998 - 198,424 302 787,980 (305,287) (1,218) 680,201
Comprehensive loss:
Net income - - - - 57,909 - 57,909
Other comprehensive income (loss):
Change in unrealized loss on debt
securities, net of reclassification amount - - - - - (92,070) (92,070)
---------
Total comprehensive loss (34,161)
Cash dividends:
Common ($1.20 per share) - - - - (34,634) - (34,634)
Preferred - - - - (22,305) - (22,305)
Additions to capital 50,584 - - - - - -
Capital stock repurchases - (6,948) (18) (18,078) (251) - (25,295)
-------- -------- ---- -------- --------- ------- ---------
BALANCE AT DECEMBER 31, 1999 50,584 191,476 284 769,902 (304,568) (93,288) 563,806
Comprehensive loss:
Net loss - - - - (51,486) - (51,486)
Other comprehensive income (loss):
Change in unrealized gain (loss) on debt
securities, net of reclassification amount - - - - - 112,733 112,733
---------
Total comprehensive income 61,247
Cash dividends:
Common ($0.71 per share) - - - - (16,568) - (16,568)
Preferred - - - - (25,546) - (25,546)
Conversion of preferred stock (25,210) - 27 25,183 - - 25,210
Additions to capital (164) - 1 144 - - 145
Capital stock repurchases - (9,236) (59) (54,616) 1,286 - (62,625)
-------- -------- ---- -------- --------- -------- ---------
BALANCE AT DECEMBER 31, 2000 $ 25,210 $182,240 $253 $740,613 $(396,882) $ 19,445 $ 545,669
======== ======== ==== ======== ========= ======== =========
See accompanying notes to consolidated financial statements.
6
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
YEAR ENDED DECEMBER 31
------------------------------------------
2000 1999 1998
- -----------------------------------------------------------------------------------------------------------------------
OPERATING ACTIVITIES:
Net income (loss) $ (51,486) $ 57,909 $ (234,764)
Noncash items:
Amortization of discount and premium 17,486 40,020 134,693
Depreciation and other amortization 986 1,043 5,010
Impairment on mortgage assets 19,088 - 4,051
Amortization and impairment of mortgage servicing rights and
related costs - - 319,886
Gain on sale of financial instruments held to offset the
effects of impairment - - (173,424)
Gain on sale of mortgage servicing rights and mortgage banking
operations - - (2,877)
Loss (gain) on sale of mortgage assets and related derivative
financial instruments 70,173 (1,738) 245,261
Net change in prepaids, receivables, other assets, accounts
payable and accrued expenses (3,371) 10,693 112,183
----------- ----------- ------------
Net cash provided by operating activities 52,876 107,927 410,019
----------- ----------- ------------
INVESTING ACTIVITIES:
Purchases of mortgage securities and other investments (2,366,925) (4,380,781) (4,797,684)
Purchases of CMO collateral and investments (235,999) - (1,305,865)
Principal collections on mortgage investments 982,118 1,247,027 2,112,469
Proceeds from sales of mortgage assets and related derivative
financial instruments 1,404,321 127,358 7,163,519
Purchases of mortgage servicing rights - - (106,498)
Purchases of derivative financial instruments held to offset
the effects of impairment - - (78,396)
Proceeds from sale of mortgage servicing rights and
mortgage banking operations - - 582,772
CMO collateral:
Principal collections 423,487 1,079,961 1,187,988
Decrease in accrued interest receivable 2,703 7,900 8,367
Decrease in short-term investments 269 14,119 721
----------- ----------- ------------
Net cash provided by (used in) investing activities 209,974 (1,904,416) 4,767,393
----------- ----------- ------------
FINANCING ACTIVITIES:
Increase (decrease) in short-term borrowings 32,240 3,032,524 (5,259,838)
Decrease in mortgage servicing acquisitions payable - - (8,363)
CMO borrowings:
Issuance of securities 235,999 - 1,494,853
Principal payments on securities (430,705) (1,241,769) (1,299,115)
Decrease in accrued interest payable (2,245) (7,513) (11,977)
Capital stock transactions (62,752) 25,289 46,235
Dividends paid (42,114) (56,939) (83,199)
----------- ----------- ------------
Net cash provided by (used in) financing activities (269,577) 1,751,592 (5,121,404)
----------- ----------- ------------
Net change in cash and cash equivalents (6,727) (44,897) 56,008
Cash and cash equivalents at beginning of year 28,488 73,385 17,377
----------- ----------- ------------
Cash and cash equivalents at end of year $ 21,761 $ 28,488 $ 73,385
=========== =========== ============
See accompanying notes to consolidated financial statements.
7
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2000
NOTE 1 -- BUSINESS
Capstead Mortgage Corporation, a mortgage investment firm operating as a real
estate investment trust ("REIT"), earns income from investing in mortgage assets
on a leveraged basis and from other investment strategies. With the election of
a new Board of Directors in April 2000, the Company modified its investment
strategy to focus on adjustable-rate and short-maturity assets, including, but
not limited to, adjustable-rate, single-family residential mortgage-backed
securities issued by government sponsored entities, either Fannie Mae, Freddie
Mac or Ginnie Mae ("Agency Securities") and credit-sensitive commercial and
residential mortgage assets. Fannie Mae, Freddie Mac and Ginnie Mae are also
referred to as FNMA, FHLMC and GNMA, respectively.
NOTE 2 -- 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 collateralized
mortgage obligations ("CMOs") and are not available for the satisfaction of
general claims of Capstead. Capstead has no responsibility for CMOs beyond the
assets pledged as collateral.
USE OF ESTIMATES
The use of estimates is inherent in the preparation of financial statements
in conformity with generally accepted accounting principles. The amortization of
premiums and discounts on mortgage assets and CMOs is based on estimates of
future movements in interest rates and how resulting rates will affect
prepayments on underlying mortgage loans. Actual results could differ from those
estimates. As was the case in 1998, prepayments could rise to levels that could
adversely affect profitability.
MORTGAGE ASSETS
Mortgage assets held in the form of mortgage-backed securities are debt
securities. Management determines the appropriate classification of debt
securities at the time of purchase and periodically reevaluates such
designation. Debt securities are classified as held-to-maturity when the Company
has the positive intent and ability to hold the securities to maturity.
Held-to-maturity securities are stated at amortized cost. Debt securities not
classified as held-to-maturity are classified as available-for-sale.
Available-for-sale
8
securities are stated at fair value with unrealized gains (losses) reported as a
separate component of Accumulated other comprehensive income (loss) in
stockholders' equity.
Interest is recorded as income when earned. Any premium or discount is
recognized as an adjustment to interest income by the interest method over the
life of the related mortgage asset. Realized gains (losses) are included in
Other revenue (expense). The cost of assets sold is based on the specific
identification method.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents include unrestricted cash on hand and highly
liquid investments with original maturities of 3 months or less.
DERIVATIVE FINANCIAL INSTRUMENTS
The Company may from time to time acquire derivative financial instruments
("Derivatives") for risk management purposes. These may include interest rate
floors, swaps and caps, U.S. Treasury futures contracts and options, written
options on mortgage assets or various other Derivatives available in the market
place that are compatible with the Company's risk management objectives. Owners
of Derivatives may have credit risk associated with the counterparties to the
instruments. The Company will manage this risk by dealing only with large,
financially sound investment banking firms.
Prior to the 1998 sales of investments in interest-only mortgage securities
and mortgage servicing rights, the Company held Derivatives, primarily interest
rate floors, as a partial hedge against the effects of falling mortgage interest
rates on the value of these investments. Realized and unrealized gains (losses)
on Derivatives designated as hedges reduced (increased) the carrying amount of
the assets hedged. Ongoing correlation and effectiveness of such Derivatives was
measured by comparing the change in value of the hedges with the change in value
of the assets hedged. If a hedge proved ineffective, hedge accounting ceased and
the change in value of the hedge instruments was reflected in operating results.
The cost of acquiring Derivatives designated as hedges was reflected as a charge
to operating results as a component of the related hedged item over the
contractual lives of the instruments. Realized and unrealized gains (losses) on
Derivatives not designated as hedges were taken directly to operating results.
Other than remaining interest rate floors sold in January 1999 and certain
clean-up call rights (see below), the Company has not held any Derivatives
during 1999 or 2000.
Statement of Financial Accounting Standards No. 133, "Accounting for
Derivative Instruments and Hedging Activities" ("SFAS 133") establishes new
accounting and reporting standards for Derivatives and hedging activities. It
requires an entity to recognize all Derivatives, including certain Derivatives
not previously afforded accounting recognition, as either assets or liabilities
on the balance sheets and to measure those instruments at fair value. If certain
conditions are met, a Derivative may be specifically designated as (i) a hedge
of the exposure to changes in the fair value of a recognized asset or liability
or an unrecognized firm commitment, (ii) a hedge of the exposure to variable
cash flows of a forecasted transaction or existing asset or liability, or (iii)
in certain circumstances, a hedge of a foreign currency exposure. The Company is
adopting SFAS 133 January 1, 2001 and is expecting to increase stockholders'
equity by $1 million due to recognizing in Other comprehensive income certain
clean-up call rights on off-balance sheet securitizations as
9
cash flow hedge instruments. These call rights will allow the Company to lock in
a maximum price for a modest amount of adjustable-rate mortgage-backed
securities that the Company expects to purchase in the future, provided certain
requirements specified in the related indentures have been met.
BORROWINGS
CMOs and borrowings under 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.
NET MARGIN ON MORTGAGE BANKING OPERATIONS
Prior to the December 1998 sale of the mortgage banking operations, the
Company earned mortgage banking revenue for servicing and, to a lesser extent,
originating single-family residential mortgage loans. This revenue is included
in Net margin on mortgage banking operations offset by related costs of
servicing including amortization and impairment of mortgage servicing rights,
net of related gains on financial instruments held to offset the effects of this
impairment. Also included in Net margin on mortgage banking operations in 1998
is the gain on the sale of this operation.
INCOME TAXES
Income taxes are accounted for using the liability method, and deferred
income tax assets and liabilities are determined based on differences between
financial reporting and tax bases of assets and liabilities and are measured
using enacted tax rates and laws that will be in effect when the differences are
expected to reverse.
Capstead and its qualified REIT subsidiaries have elected to be taxed as a
REIT and intend to continue to do so. As a result of this election, the Company
is not taxed on taxable income distributed to stockholders if certain REIT
qualification tests are met. It is Capstead's policy to distribute 100% of
taxable income of the REIT 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. Capstead's non-REIT subsidiaries file a separate
consolidated federal income tax return and are subject to income taxes.
STOCK-BASED COMPENSATION
Compensation cost for stock-based awards for employees is generally
measured as the excess, if any, of the quoted market price of the Company's
stock at the date of the grant over the amount to be paid to acquire the stock
and is recognized as compensation expense as the awards vest and restrictions
lapse.
1-FOR-2 REVERSE COMMON STOCK SPLIT
In April 2000, stockholders approved a 1-for-2 reverse common stock split
that was effective the close of business on May 8, 2000. Concurrent with the
reverse split, the
10
conversion ratio for each series of preferred shares was adjusted accordingly.
All share and per share information presented has been restated to reflect the
reverse common stock split.
NOTE 3 -- NET INCOME (LOSS) PER COMMON SHARE
Basic net income (loss) per common share is computed by dividing net income
(loss) after deducting preferred share dividends, as herein defined, by the
weighted average number of common shares outstanding. Diluted net income (loss)
per common share is computed by dividing net income (loss), after deducting
preferred share dividends for antidilutive convertible preferred shares, by the
weighted average number of common shares, dilutive stock options and dilutive
convertible preferred shares outstanding. The components of the computation of
basic and diluted net income (loss) per share were as follows (in thousands,
except per share data):
YEAR ENDED DECEMBER 31
--------------------------------------
2000 1999 1998
--------------------------------------------------------------------------------------------------------------
NUMERATOR FOR BASIC NET INCOME (LOSS) PER COMMON SHARE:
Net income (loss) $(51,486) $ 57,909 $(234,764)
Less preferred share dividends* (24,260) (22,556) (22,342)
-------- -------- ---------
$(75,746) $ 35,353 $(257,106)
======== ======== =========
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING 22,973 29,174 30,474
====== ====== ======
BASIC NET INCOME (LOSS) PER COMMON SHARE $(3.30) $1.21 $(8.44)
====== ===== ======
NUMERATOR FOR DILUTED NET INCOME (LOSS) PER COMMON SHARE:
Net income (loss) $(51,486) $ 57,909 $(234,764)
Less cash dividends paid on antidilutive convertible
preferred shares:
Series A (598) (598) (610)
Series B (20,322) (21,391) (21,732)
Series B repurchase amount less than (in excess of) book value* 1,286 (251) -
Series C (3,012) - **
Series D (1,614) - **
-------- -------- ---------
$(75,746) $ 35,669 $(257,106)
======== ======== =========
DENOMINATOR FOR DILUTED NET INCOME (LOSS) PER COMMON SHARE:
Weighted average common shares outstanding 22,973 29,174 30,474
Net effect of dilutive stock options - 10 -
Net effect of dilutive preferred shares - 339 -
------ ------ ------
22,973 29,523 30,474
====== ====== ======
DILUTED NET INCOME (LOSS) PER COMMON SHARE $(3.30) $1.21 $(8.44)
====== ===== ======
* Included as a component of the Series B preferred share dividends in the
calculation of both basic and diluted net income (loss) per common share,
is the difference between repurchase amounts and the Series B preferred
shares book value of $11.17 per share.
** Not applicable.
11
NOTE 4 -- MORTGAGE SECURITIES AND OTHER INVESTMENTS
Mortgage investments and the related weighted average interest rates were
as follows (dollars in thousands):
AVERAGE
PRINCIPAL PREMIUMS CARRYING VERAGE EFFECTIVE
BALANCE (DISCOUNTS) BASIS AMOUNT COUPON RATE
----------------------------------------------------------------------------------------------------
* ** **
DECEMBER 31, 2000
Agency Securities:
FNMA/FHLMC:
Fixed-rate $ 3,411 $ 16 $ 3,427 $ 3,646 10.00% 6.26%
Medium-term 586,954 (5,357) 581,597 585,756 6.19 6.52
LIBOR/CMT ARMs 2,176,060 40,140 2,216,200 2,225,118 8.19 6.81
COFI ARMs 209,721 (4,957) 204,764 208,672 6.78 6.82
GNMA ARMs 2,181,958 18,323 2,200,281 2,199,649 7.07 6.51
---------- ------- ---------- ---------- ------ ----
5,158,104 48,165 5,206,269 5,222,841 7.43 6.59
Non-agency securities 94,538 - 94,538 96,390 8.44 7.98
CMBS - adjustable-rate 74,920 (688) 74,232 75,228 8.68 9.07
---------- -------- ---------- ---------- ------ ----
$5,327,562 $47,477 $5,375,039 $5,394,459 7.47% 6.68%
========== ======= ========== ========== ====== ====
DECEMBER 31, 1999
Agency Securities:
FNMA/FHLMC:
Fixed-rate $1,063,822 $ (2,924) $1,060,898 $1,009,577 6.18% 6.23%
Medium-term 1,123,984 4,516 1,128,500 1,103,704 6.15 5.89
LIBOR/CMT ARMs 911,262 20,824 932,086 935,291 7.03 5.63
COFI ARMs 242,573 1,570 244,143 237,721 5.84 5.62
GNMA ARMs 1,924,659 26,083 1,950,742 1,936,032 6.29 5.65
---------- ------- ---------- ---------- ---- ----
5,266,300 50,069 5,316,369 5,222,325 6.35 5.81
Non-agency securities 126,431 385 126,816 127,059 8.34 8.06
CMBS - adjustable-rate 60,182 (852) 59,330 59,330 7.54 8.53
---------- ------- ---------- ---------- ---- ----
$5,452,913 $49,602 $5,502,515 $5,408,714 6.41% 5.87%
========== ======= ========== ========== ==== ====
* Includes mark-to-market for securities classified as available-for-sale, if
applicable (see NOTE 8).
** Average Coupon is presented as of the indicated balance sheet date. Average
Effective Rate is presented for the year then ended, calculated including
mortgage insurance costs on non-agency securities and excluding unrealized
gains and losses.
The Company classifies its Agency Securities and non-agency securities by
interest rate characteristics of the underlying single-family residential
mortgage loans. Commercial mortgage-backed securities ("CMBS") are classified in
a similar fashion. Fixed-rate mortgage securities either (i) have fixed rates of
interest for their entire terms, (ii) have an initial fixed-rate period of 10
years after origination and then adjust annually based on a specified margin
over the 1-year Constant Maturity U.S. Treasury Note Rate ("1-year CMT"), or
(iii) were previously classified as medium-term and have adjusted to a fixed
rate for the remainder of their terms. Medium-term mortgage securities either
(i) have an initial fixed-rate period of 3 or 5 years after origination and then
adjust annually based on a specified margin over 1-year CMT, (ii) have initial
interest rates that adjust one time, approximately 3 or 5 years after
origination, based on a specified margin over Fannie Mae yields for 30-year,
fixed-rate commitments at the time of adjustment, or (iii) are fixed-rate
mortgage securities that have expected weighted average lives of 5 years or
less. Adjustable-
12
rate mortgage ("ARM") securities either (i) adjust annually based on a specified
margin over 1-year CMT, (ii) adjust semiannually based on a specified margin
over the 6-month London Interbank Offered Rate ("LIBOR"), (iii) adjust monthly
based on a specific margin over the Cost of Funds Index as published by the
Eleventh District Federal Reserve Bank ("COFI"), or (iv) were previously
classified as medium-term and have begun adjusting annually based on a specified
margin over 1-year CMT. CMBS held as of December 31, 2000 adjust monthly based
on a specified margin over 30-day LIBOR.
Agency Securities are AAA-rated and have no foreclosure risk. Non-agency
securities consist of private mortgage pass-through securities backed primarily
by single-family jumbo-sized residential mortgage loans whereby the related
credit risk of the underlying loans is borne by AAA-rated private mortgage
insurers and other AAA-rated private mortgage securities (together, "Non-agency
Securities"). Although currently investment grade, CMBS held by the Company at
December 31, 2000 carry credit risk associated with the underlying commercial
mortgage loans. Features of the related CMBS issuance, including subordinated
securities held by other investors, help mitigate this risk. The maturity of
mortgage-backed securities is directly affected by the rate of principal
prepayments on the underlying loans.
In connection with modifying its investment strategy in April 2000, the
Company sold $1.4 billion of fixed-rate and medium-term mortgage investments and
designated for sale nearly $700 million of primarily medium-term securities,
incurring a charge to operating results of $90.0 million. The charge consisted
of $70.9 million of realized losses included in Gain (loss) on sale of mortgage
assets and related derivative financial instruments, and a $19.1 million
reduction in the Company's basis in securities designated for sale, included in
Impairment on mortgage assets. In January 2001, the Company sold $442 million of
medium-term securities, most of which had been previously designated for sale,
recognizing a gain in 2001 of $5.7 million.
NOTE 5 -- CMO COLLATERAL AND INVESTMENTS
CMO collateral consists of fixed-rate, medium-term and adjustable-rate
mortgage securities collateralized by single-family residential mortgage loans
and related short-term investments, both pledged to secure CMO borrowings
("Pledged CMO Collateral"). All principal and interest on pledged mortgage
securities is remitted directly to collection accounts maintained by a trustee.
The trustee is responsible for reinvesting those funds in short-term
investments. All collections on the pledged mortgage securities and the
reinvestment income earned thereon are available for the payment of principal
and interest on CMO borrowings. Pledged mortgage securities are private mortgage
pass-through securities whereby the related credit risk of the underlying loans
is borne by AAA-rated private mortgage insurers or subordinated bonds within the
related CMO series to which the collateral is pledged. The Company has only
$799,000 of credit risk held in the form of subordinated bonds associated with
these securities. The weighted average effective interest rate for total Pledged
CMO Collateral was 7.28% and 7.16% during 2000 and 1999, respectively.
CMO investments currently consist of reserve funds retained by the Company
in connection with two 1993 mortgage loan sales. These reserve funds are
available to pay special hazard (e.g. earthquake or mudslide-related losses) or
certain bankruptcy costs associated with approximately $128 million of loans
outstanding as of December 31, 2000
13
from the related securitizations. The components of CMO collateral and
investments were as follows (in thousands):
DECEMBER 31
------------------------
2000 1999
- --------------------------------------------------------------------------------
Pledged CMO Collateral:
Pledged mortgage securities $3,088,579 $3,283,848
Short-term investments 491 760
Accrued interest receivable 18,675 19,461
---------- ----------
3,107,745 3,304,069
Unamortized premium 16,322 11,633
---------- ----------
3,124,067 3,315,702
CMO investments 2,811 3,184
---------- ----------
$3,126,878 $3,318,886
========== ==========
In 1998 the Company sold its entire $1.0 billion Agency Trust interest-only
mortgage securities portfolio at a loss of $251.9 million, net of related gains
on Derivatives, and wrote down to fair value remaining investments in
interest-only mortgage securities through an other-than-temporary impairment
charge of $4.1 million. These remaining securities were sold in early 1999. For
a short period of time prior to the sale of these assets, Derivatives held to
help offset the effects of falling mortgage interest rates under-performed
relative to the loss in value of the assets they were intended to hedge.
Therefore, these Derivatives no longer met hedge accounting criteria requiring
ongoing correlation and hedge accounting ceased. Included in Gain (loss) on sale
of mortgage assets and related derivative financial instruments are changes in
value of these instruments totaling $28.3 million that occurred during this
time.
NOTE 6 -- BORROWINGS UNDER REPURCHASE ARRANGEMENTS
Borrowings made under uncommitted repurchase arrangements with investment
banking firms pursuant to which the Company pledges mortgage securities as
collateral generally have maturities of less than 31 days. Repurchase
arrangements with CMBS pledged as collateral generally have longer maturities,
to more closely coincide with the expected maturities of the related collateral.
The terms and conditions of these arrangements are negotiated on a
transaction-by-transaction basis. Repurchase arrangements and related weighted
average interest rates, classified by type of collateral and maturities, were as
follows (dollars in thousands):
DECEMBER 31, 2000 DECEMBER 31, 1999
--------------------------- ------------------------
BORROWINGS AVERAGE BORROWINGS AVERAGE
OUTSTANDING RATE OUTSTANDING RATE
----------------------------------------------------------------------------- ------------------------
Agency Securities (less than 31 days) $4,616,784 6.58% $2,405,436 5.81%
Agency Securities (31 to 90 days) 218,104 6.55 2,012,810 6.38
Agency Securities (over 90 days) - - 280,347 6.41
Non-agency Securities (less than 31 days) 6,947 6.90 - -
Non-agency Securities (over 90 days) - - 124,361 6.62
CMBS (less than 1 year) 49,145 7.25 - -
CMBS (over 1 year) 13,652 7.25 49,438 7.01
---------- ---- ---------- ----
$4,904,632 6.59% $4,872,392 6.11%
========== ==== ========== ====
14
The weighted average effective interest rate on borrowings under repurchase
arrangements was 6.31% and 5.16% during 2000 and 1999, respectively. Interest
paid on borrowings totaled $301.1 million, $221.4 million and $347.6 million
during 2000, 1999 and 1998, respectively.
NOTE 7 -- CMO BORROWINGS
Each series of CMOs issued consists of various classes of bonds, most of
which have fixed rates of interest. Interest is payable monthly or quarterly 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 of bonds until all classes having
an earlier stated maturity have been paid in full. The components of CMOs along
with selected other information were as follows (dollars in thousands):
DECEMBER 31
-------------------------------
2000 1999
----------------------------------------------------------------------------
CMOs $3,087,167 $3,281,464
Accrued interest payable 17,768 18,096
---------- ----------
Total obligation 3,104,935 3,299,560
Unamortized discount (1,061) (9,976)
---------- ----------
$3,103,874 $3,289,584
========== ==========
Range of average interest rates 4.95% to 9.45% 5.13% to 9.45%
Range of stated maturities 2008 to 2030 2008 to 2028
Number of series 26 25
The maturity of each CMO series is directly affected by the rate of
principal prepayments on the related Pledged CMO Collateral. Each series is also
subject to redemption, generally at the Company's option, provided that certain
requirements specified in the related indenture have been met (referred to as
"Clean-up Calls"); therefore, the actual maturity of any series is likely to
occur earlier than its stated maturity. The weighted average effective interest
rate for all CMOs was 7.35% and 7.24% during 2000 and 1999, respectively.
Interest paid on CMOs totaled $226.6 million, $260.2 million and $352.6 million
during 2000, 1999 and 1998, respectively.
NOTE 8 -- DISCLOSURES REGARDING FAIR VALUES
OF DEBT SECURITIES
Estimated fair values of debt securities have been determined using
available market information and appropriate valuation methodologies; however,
considerable judgment is required in interpreting market data to develop these
estimates. In addition, fair values fluctuate on a daily basis. Accordingly,
estimates presented herein are not necessarily indicative of the amounts that
could be realized in a current market exchange. The use of different market
assumptions and/or estimation methodologies may have a material effect on
estimated fair values.
The carrying amounts of cash and cash equivalents, receivables, payables
and borrowings under repurchase arrangements approximate fair value. The fair
value of Agency Securities,
15
Non-agency Securities, CMBS and CMO investments were estimated using either (i)
quoted market prices when available, including quotes made by lenders in
connection with designating collateral for repurchase arrangements, or (ii)
offer prices for similar assets or market positions. The fair value of Pledged
CMO Collateral was based on projected cash flows, after payment on the related
CMOs, determined using market discount rates and prepayment assumptions. The
fair value of CMOs was based on the same method for determining fair value of
Pledged CMO Collateral adjusted for credit enhancements. The maturity of
mortgage assets is directly affected by the rate of principal payments on the
underlying mortgage loans and, for Pledged CMO Collateral, Clean-up Calls of the
remaining CMOs outstanding. Fair value disclosures for financial instruments
were as follows (in thousands):
DECEMBER 31, 2000 DECEMBER 31, 1999
---------------------- -----------------------
CARRYING FAIR CARRYING FAIR
AMOUNT VALUE AMOUNT VALUE
- -----------------------------------------------------------------------------------------------
ASSETS:
Cash and cash equivalents $ 21,761 $ 21,761 $ 28,488 $ 28,488
Restricted cash and cash equivalents - - 2,500 2,500
Receivables 61,587 61,587 42,297 42,297
Mortgage investments 5,394,459 5,394,459 5,408,714 5,409,991
CMO collateral and investments 3,126,878 3,084,153 3,318,886 3,255,730
LIABILITIES:
Payables 31,112 31,112 30,673 30,673
Borrowings under repurchase arrangements 4,904,632 4,904,632 4,872,392 4,872,392
CMOs 3,103,874 3,074,271 3,289,584 3,242,991
Fair value disclosures for available-for-sale debt securities were as
follows (in thousands):
GROSS GROSS
COST UNREALIZED UNREALIZED FAIR
BASIS GAINS LOSSES VALUE
- ------------------------------------------------------------------------------------------
AS OF DECEMBER 31, 2000
Agency Securities:
Fixed-rate $ 3,427 $ 219 $ - $ 3,646
Medium-term 581,597 5,176 1,017 585,756
ARMs 4,621,245 20,165 7,971 4,633,439
---------- ------- ------- ----------
5,206,269 25,560 8,988 5,222,841
Non-agency securities 94,538 1,852 - 96,390
CMBS - adjustable-rate 74,232 996 - 75,228
CMO collateral and investments 74,648 196 171 74,673
---------- ------- ------- ----------
$5,449,687 $28,604 $ 9,159 $5,469,132
========== ======= ======= ==========
AS OF DECEMBER 31, 1999
Agency Securities:
Fixed-rate $1,060,898 $ 268 $51,589 $1,009,577
Medium-term 1,128,500 39 24,835 1,103,704
ARMs 3,126,971 4,659 22,586 3,109,044
---------- ------- ------- ----------
5,316,369 4,966 99,010 5,222,325
Non-agency Securities 28,817 249 6 29,060
CMBS - adjustable-rate 59,330 - - 59,330
CMO collateral and investments 103,142 697 184 103,655
---------- ------- ------- ----------
$5,507,658 $ 5,912 $99,200 $5,414,370
========== ======= ======= ==========
16
Held-to-maturity debt securities consist of Pledged CMO Collateral and
collateral released from the related CMO indentures pursuant to Clean-up Calls
and held as Non-agency Securities. Fair value disclosures for debt securities
held-to-maturity were as follows (in thousands):
GROSS GROSS
COST UNREALIZED UNREALIZED FAIR
BASIS GAINS LOSSES VALUE
- ------------------------------------------------------------------------------------------
AS OF DECEMBER 31, 2000
Pledged CMO Collateral $3,052,205 $ 1,204 $14,326 $3,039,083
========== ======= ======= ==========
AS OF DECEMBER 31, 1999
Non-agency Securities $ 97,999 $ 1,277 $ - $ 99,276
Pledged CMO Collateral 3,215,231 1,620 18,183 3,198,668
---------- ------- ------- ----------
$3,313,230 $ 2,897 $18,183 $3,297,944
========== ======= ======= ==========
Sales of released CMO collateral occasionally occur provided the collateral
has paid down to within 15% of its original issuance amounts. Dispositions of
debt securities were as follows (in thousands):
YEAR ENDED DECEMBER 31
-----------------------------------
2000 1999 1998
- --------------------------------------------------------------------------------------
Sale of securities held available-for-sale:
Amortized cost $1,389,947 $7,573 $6,233,622
Gain (loss)* (70,989) 1,761 (223,959)
Sale of released CMO collateral held-to-maturity:
Amortized cost 84,547 - 5,022
Gain 816 - 471
* When combined with impairment of mortgage assets, these amounts represent
the reclassification amounts included in "Other comprehensive income
(loss)" as a component of the "Change in unrealized gains (losses) on debt
securities" held available-for-sale. Excludes a January 1999 loss of
$23,000 on the sale of Derivatives.
NOTE 9 -- SALE OF MORTGAGE BANKING OPERATIONS AND
MORTGAGE BANKING RELATED DISCLOSURES
In December 1998, the Company sold its mortgage banking operations
including its investment in mortgage servicing rights to two affiliates of
General Motors Acceptance Corporation ("GMAC"). Prior to the sale, the Company
had a long-term subservicing relationship with GMAC. A gain of $2.9 million on
these transactions was recorded as a component of Net margin on mortgage banking
operations. Also included as a component of Net margin on mortgage banking
operations are mortgage servicing right impairment charges totaling $224.7
million incurred during 1998 and gains on the sale of Derivatives and U.S.
Treasury notes held to partially offset the effects of this impairment of $173.4
million.
After retiring indebtedness related to the mortgage servicing portfolio,
related hedge instruments and loan production financing, and after certain
transaction costs, these transactions generated net cash proceeds of
approximately $500 million. As of December 31, 2000, included in Accounts
payable and accrued expenses are remaining accruals of less than $3 million
pertaining to indemnifying GMAC for costs of mortgage loan buyback requests by
investors in excess of existing indemnifications by the originators of the loans
17
and other contingencies associated with the sale. The Company is unaware of any
other material indemnification-related claims that may arise from this
transaction.
NOTE 10 -- INCOME TAXES
Capstead and its qualified REIT subsidiaries file a separate federal income
tax return that does not include the operations of the non-REIT subsidiaries.
Provided all taxable income of Capstead and its qualified REIT subsidiaries is
distributed to stockholders within time limits prescribed by the Code, no income
taxes are due on this income. Taxable income of the non-REIT subsidiaries is
fully taxable. In connection with utilizing operating loss carryforwards,
alternative minimum taxes of $2,000 and $1.6 million were paid during 2000 and
1998, respectively. No income taxes were paid during 1999. Effective tax rates
differed substantially from statutory federal income tax rates because of the
effect of the following items (in thousands):
YEAR ENDED DECEMBER 31
---------------------------------
2000 1999 1998
- ---------------------------------------------------------------------------------------------------
Income taxes computed at the federal statutory rate $(18,020) $ 20,268 $(82,167)
Nondeductible capital loss 24,764 - 83,651
Benefit of REIT status (6,805) (20,271) (3,650)
-------- -------- --------
Income taxes computed on income of non-REIT subsidiaries (61) (3) (2,166)
Change in unrecognized deferred income tax asset (235) 839 (667)
Tax effect of capital contributions to non-REIT subsidiaries - - 3,783
Other* 298 (836) 650
--------- -------- --------
$ 2 $ - $ 1,600
========= ======== ========
* The 1998 provision for income taxes is reflected in the statement of
operations as an offset to "Net margin on mortgage banking operations."
Significant components of deferred income tax assets and liabilities were
as follows (in thousands):
DECEMBER 31
------------------
2000 1999
------------------------------------------------------------------
Deferred income tax assets:
Alternative minimum tax credit $1,753 $1,751
Net operating loss carryforwards 1,149 1,235
Other 668 619
------ -------
3,570 3,605
Deferred income tax liabilities (544) (344)
------ --------
Net deferred tax assets $3,026 $3,261
====== ======
Valuation allowance $3,026 $3,261
====== ======
At December 31, 2000 Capstead and its qualified REIT subsidiaries had
capital loss carryforwards for tax purposes of $331 million, of which $261
million expires after 2003, and $70 million expires after 2005. At December 31,
2000 the non-REIT subsidiaries had net operating loss carryforwards for tax
purposes of $7.1 million, of which $3.6 million expires after 2012, and $3.5
million expires after 2019. In addition, the non-REIT subsidiaries have
18
sufficient alternative minimum tax credit carryforwards to offset the payment of
federal income taxes on $5.0 million of future taxable income, if any, earned by
these subsidiaries.
NOTE 11 -- STOCKHOLDERS' EQUITY AND PREFERRED STOCK
SUBJECT TO REPURCHASE
As of December 31, 2000, the Company had 3 series of convertible preferred
stock outstanding, each entitled to cumulative fixed dividends with redemption
and liquidation preferences as indicated below (dollars in thousands, except per
share amounts):
PER SHARE
------------------------------------------------------------------ AGGREGATE
PREFERRED ANNUALIZED CONVERSION REDEMPTION LIQUIDATION LIQUIDATION
SERIES DIVIDEND RATE PRICE PREFERENCE PREFERENCE
-------------------------------------------------------------------------------------------------------
*
A $1.60 1.1049 $16.40 $16.40 $ 6,134
B 1.26 0.3844 12.50 11.38 180,316
C 0.56 0.5000 6.56 6.89 37,054
* Reflects number of common shares to be received for each preferred
share converted. During 2000, 36 Series A shares and 1,791 Series B
shares were converted into 39 and 674 common shares, respectively.
The preferred shares rank on parity with each other and prior to the common
shares in the event of liquidation of the Company. The Series A and B shares are
nonvoting, while the Series C shares vote with the common shares on an
as-converted basis. The Series A and B shares are currently redeemable at the
Company's option, while the Series C shares become redeemable at the Company's
option anytime after December 9, 2004. However, the Company may be required to
repurchase the Series C shares at the original issue price of $4.76 per share,
in certain circumstances as discussed below. Additionally, the Series C shares
automatically convert into common shares on December 31, 2009. Dividends are
payable quarterly for the Series A and C shares and monthly for the Series B
shares. Dividends paid for each preferred stock issue were as follows (dollars
in thousands, except per share amounts):
2000 1999 1998
----------------- ----------------- ------------------
PREFERRED PER IN PER IN PER IN
SERIES SHARE AGGREGATE SHARE AGGREGATE SHARE AGGREGATE
-------------------------------- ----------------- ------------------
A $1.60 $ 598 $1.60 $ 598 $1.60 $ 610
B 1.26 20,322 1.26 21,391 1.26 21,732
C 0.56 3,012 0.03 185 - -
D* 0.30 1,614 0.02 131 - -
* On December 28, 2000 the Series D shares were converted into 2,689,000
common shares.
On December 9, 1999 the Company issued 5,378,000 of the Series C shares and
5,378,000 of the Series D shares to an affiliate of Fortress Investment Group
LLC at a cash price of $4.76 per share representing aggregate proceeds of $51.2
million, before offering expenses (together Fortress Investment Group LLC and
its affiliates are referred to as "Fortress"). In connection with this issuance,
the Company entered into a Supplemental Agreement, as amended, which, among
other things, provides that if there is a change in
19
control anytime prior to April 20, 2005, then Fortress will have the right to
cause the repurchase of any of these preferred shares not previously converted
into common shares for $4.76 per share, plus all accrued and unpaid dividends. A
change in control is deemed to have occurred if (i) a person acquires 25% of the
voting power of the Company, (ii) directors elected and qualified at an annual
stockholder meeting cease to constitute at least a majority of the Board of
Directors (the "Board"), or (iii) the Company is a party to a business
combination not approved by certain Fortress representatives on the Board.
In December 1998, the Company completed a previously authorized repurchase
of 500,000 common shares at an average price of $8.20 per share. In early 1999,
formerly restricted common shares totaling 42,792 were repurchased at $8.24 per
share. In February 1999, the Board authorized the repurchase of up to 3 million
common shares and up to 2 million Series B shares. During 2000 and 1999, the
Company repurchased 376,950 and 1,803,750 common shares, respectively, at an
average price of $7.77 and $9.83 pursuant to this repurchase program. In
addition, pursuant to this program, 826,900 and 622,000 Series B shares were
repurchased during 2000 and 1999, respectively, at an average price of $9.61 and
$11.57. On January 25, 2000 the Company repurchased 5,568,500 common shares at a
price of $9.27 per share pursuant to a tender offer that commenced December 9,
1999 and closed January 14, 2000. All repurchased shares have been cancelled.
All per share prices calculated including transaction costs.
On February 16, 2001 the Company commenced a tender offer to purchase up to
5 million common shares at $12.75 per share. The offer is expected to be
completed by March 16, 2001, unless extended by the Company.
In early 1998 and prior, the Company used dividend reinvestment, direct
stock purchase and structured equity shelf programs to raise new equity capital
at favorable prices. Dividend reinvestments allowed existing stockholders to
convert cash dividends into newly issued shares. Similarly, direct stock
purchases allowed investors the opportunity to acquire additional shares
directly from the Company, subject to certain limitations. Structured equity
shelf issuances represented new shares issued by the Company on a daily basis
either directly into the market or in larger blocks to qualified buyers, subject
to certain limitations. The Company raised $44.4 million from the sale of
1,163,613 common shares and $4.0 million from the sale of 273,976 Series B
shares during 1998, prior to indefinitely suspending these programs.
Option exercises by former members of the Board resulted in net additions
to capital of $37,000 during 2000. No options were exercised in 1999. Option
exercises by employees during 1998 resulted in net additions to capital of $1.9
million.
The Company's Charter provides that if the Board 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
common and/or preferred shares sufficient to maintain or bring such ownership
into conformity with the Code. In addition, the Company may refuse to transfer
or issue common and/or preferred shares to any person whose acquisition would
result in Capstead being unable to comply with the requirements of the Code.
Finally, the Charter provides that the Company may redeem or refuse to transfer
any capital shares 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.
20
NOTE 12 -- EMPLOYEE BENEFIT PLANS
The Company sponsors stock plans for directors and employees to provide for
the issuance of stock options, nonvested stock and other incentive-based stock
awards (collectively, the "Plans"). The Plans provide for the issuance of up to
an aggregate of 3,756,250 common shares. Options granted have terms and vesting
requirements at the grant date of up to 10 years. Prior to a restructuring of
long-term incentive compensation for key officers on January 2, 1998 which
eliminated this feature, most of the outstanding stock options provided for the
annual granting of dividend equivalent rights ("DERs") that permitted the option
holder to obtain additional common shares based upon formulas set forth in the
Plans. The following tables provide information regarding common stock option
activity for the periods indicated and significant option grants outstanding as
of December 31, 2000:
NUMBER OF WEIGHTED AVERAGE
SHARES EXERCISE PRICE
-------------------------------------------------------------------------------------------
As of December 31, 1997 (939,210 exercisable) 1,374,212 $29.82
Granted (average fair value: $2.97 per share) 907,125 40.00
Exercised (80,773) 23.50
Canceled (345,063) 13.94
DERs granted (average fair value: $10.00 per share) 118,871 -
----------
As of December 31, 1998 (1,974,372 exercisable)* 1,974,372 35.74
Granted (average fair value: $1.39 per share) 5,625 8.25
Canceled* (1,231,225) 35.62
----------
As of December 31, 1999 (748,772 exercisable) 748,772 35.71
Granted (average fair value: $0.96 per share) 233,341 7.15
Exercised (4,590) 8.15
Canceled (497,035) 35.40
DERs granted (average fair value: $8.38 per share) 2,613 -
----------
As of December 31, 2000 (324,973 exercisable) 483,101 22.31
==========
* With the December 1998 sale of the mortgage banking operations, all
stock option awards then outstanding became 100% vested. Unexercised
options held by employees of the mortgage banking operations lapsed in
1999.
WEIGHTED
AVERAGE
OPTIONS OPTIONS EXERCISE REMAINING
GRANT DATE OUTSTANDING EXERCISABLE PRICE LIFE (YEARS)
-------------------------------------------------------------------------------------------------------
After December 1998 230,325 72,197 $7.12 9
January 1998 and prior 252,776 252,776 36.21 6
Nonvested stock grants are subject to certain restrictions, including
continuous employment, which generally lapsed over periods of up to 10 years.
Costs associated with nonvested stock grants (measured by the fair value of the
common shares on the date of grant multiplied by the number of shares granted)
are recognized as compensation expense over the vesting period. However, with
the December 1998 sale of the mortgage banking operations, all remaining
restrictions lapsed under the terms of the Plans for grants made prior to that
date. This included nonvested stock grants for 226,313 common shares issued
January 2, 1998 (grant date fair value $40 per share) in connection with a
restructuring of long-term
21
incentive compensation for key officers, and additional 1998 grants aggregating
17,500 common shares (grant date fair values averaging $22.36 per share).
Included in the gain on sale of the mortgage banking operations is a $11.0
million charge to eliminate all deferred compensation related to nonvested stock
grants.
Nonvested stock grants for 107,153 common shares were issued to employees
other than the chairman on April 20, 2000 (grant date fair value $7.125 per
share). Restrictions on these grants generally lapse over 5 years.
The Company applies Accounting Principles Board Opinion No. 25, "Accounting
for Stock Issued to Employees," and related Interpretations in accounting for
stock awards. Accordingly, no compensation expense has been recognized for stock
awards other than for DERs and nonvested stock grants. Related compensation
costs, excluding the charge mentioned above, totaled $108,000 and $2.4 million
in 2000 and 1998, respectively. There were no related compensation costs during
1999. The effect of determining compensation cost for stock options granted
since the beginning of 1995, based upon the estimated fair value at the grant
date consistent with the methodology prescribed under Statement of Financial
Accounting Standards No. 123, "Accounting for Stock-Based Compensation," would
have been $0.03 per share or less on diluted net income (loss) per common share
for each of the last 3 years. This effect on diluted net income (loss) per
common share was determined using a Black-Scholes option pricing model and,
depending upon each individual option grant during the last three years,
dividend yields of 10% to 12%, volatility factors of 30% to 53%, expected life
assumptions of 1 to 5 years and risk-free rates of between 4.7% and 6.3%. This
effect may not be representative of the pro forma effect on future operating
results.
The Company also sponsors a qualified defined contribution retirement plan
for all employees. The Company matches up to 50% of a participant's voluntary
contribution up to a maximum of 6% of a participant's compensation and may make
additional contributions of up to another 3% of a participant's compensation.
All Company contributions are subject to certain vesting requirements.
Contribution expenses were $161,000, $113,000 and $709,000 in 2000, 1999 and
1998, respectively.
NOTE 13 -- COMMITMENTS AND CONTINGENCIES
During 1998, twenty-four purported class action lawsuits were filed against
the Company and certain of its officers alleging, among other things, that the
defendants violated federal securities laws by publicly issuing false and
misleading statements and omitting disclosure of material adverse information
regarding the Company's business during various periods between January 28, 1997
and July 24, 1998. The complaints claim that as a result of such alleged
improper actions, the market price of the Company's equity securities were
artificially inflated during that time period. The complaints seek monetary
damages in an undetermined amount. In March 1999, these actions were
consolidated and in July 2000, a lead plaintiff group was appointed by the
court. An amended complaint was filed October 20, 2000. On February 20, 2001 the
Company responded to this amended complaint. The Company believes it has
meritorious defenses to the claims and intends to vigorously defend the actions.
Based on available information, management believes the resolution of these
suits will not have a material adverse effect on the financial position of the
Company.
22
NOTE 14 -- TRANSACTIONS WITH FORTRESS
Through acquisitions of preferred and common shares, Fortress is the
Company's largest stockholder controlling 33% of the voting shares of the
Company as of December 31, 2000. At the Company's April 2000 annual meeting,
stockholders elected a new seven member Board of Directors, including four
members designated by Fortress. Wesley R. Edens, chairman of the board of
Fortress, was then appointed Capstead's Chairman of the Board and Chief
Executive Officer. The Company entered into a management contract with Fortress
with an effective date of April 20, 2000, pursuant to which Fortress provides
the services of Mr. Edens and of other individuals as necessary to perform
support services for Mr. Edens. This contract renews annually on December 31
unless terminated by Fortress or by majority vote of the independent members of
the Board of Directors.
Under the terms of this contract, Fortress is entitled to receive a base
annual fee of $375,000 plus an annual cash incentive bonus based on a
predetermined formula established by the independent Directors. In addition, at
these Directors sole discretion, Fortress may be awarded long-term noncash
incentive compensation, which may be in the form of stock options or grants.
Included in Other operating expense is $390,625 cash compensation Fortress
received pursuant to this arrangement for services rendered from April 20, 2000
through December 31, 2000.
Under separate arrangement, the Company provided accounting and cash
management services to Fortress for one of its affiliates. Included in Other
revenue is $160,000 Capstead received pursuant to this arrangement for services
rendered through December 31, 2000.
NOTE 15 -- NET INTEREST INCOME ANALYSIS (UNAUDITED)
The following summarizes interest income and interest expense and weighted
average interest rates (dollars in thousands):
2000 1999 1998
--------------------- -------------------- ----------------------
AVERAGE AVERAGE AVERAGE
EFFECTIVE EFFECTIVE EFFECTIVE
AMOUNT RATE AMOUNT RATE AMOUNT RATE
- --------------------------------------------------------------- -------------------- ----------------------
Interest income:
Mortgage securities and other
investments $349,533 6.68% $293,841 5.87% $311,807 5.89%
CMO collateral and investments 237,052 7.28 269,318 7.16 355,391 7.28
-------- -------- --------
Total interest income 586,585 563,159 667,198
-------- -------- --------
Interest expense:
Borrowings under repurchase
arrangements 303,126 6.31 232,852 5.16 313,858 5.55
CMOs 237,479 7.35 270,081 7.24 340,248 7.85
-------- -------- --------
Total interest expense 540,605 502,933 654,106
-------- -------- --------
$ 45,980 $ 60,226 $ 13,092
======== ======== ========
23
Changes in interest income and interest expense due to changes in interest
rates versus changes in volume were as follows (in thousands):
RATE VOLUME TOTAL
-------------------------------------------------------------------------------------
* * *
2000/1999
Interest income:
Mortgage securities and other investments $ 41,680 $ 14,012 $ 55,692
CMO collateral and investments 4,225 (36,491) (32,266)
-------- --------- ---------
Total interest income 45,905 (22,479) 23,426
-------- --------- ---------
Interest expense:
Borrowings under repurchase arrangements 54,327 15,947 70,274
CMOs 3,828 (36,430) (32,602)
-------- --------- ---------
Total interest expense 58,155 (20,483) 37,672
-------- --------- ---------
$(12,250) $ (1,996) $ (14,246)
======== ========= =========
1999/1998
Interest income:
Mortgage securities and other investments $ (793) $ (17,173) $ (17,966)
CMO collateral and investments (5,673) (80,400) (86,073)
-------- --------- ---------
Total interest income (6,466) (97,573) (104,039)
-------- --------- ---------
Interest expense:
Borrowings under repurchase arrangements (20,758) (60,248) (81,006)
CMOs (25,188) (44,979) (70,167)
-------- --------- ---------
Total interest expense (45,946) (105,227) (151,173)
-------- --------- ---------
$ 39,480 $ 7,654 $ 47,134
======== ========= =========
* The change in interest income and interest expense 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.
NOTE 16 -- QUARTERLY RESULTS (UNAUDITED)
Summarized quarterly results of operations were as follows (in thousands,
except percentages and per share amounts). See NOTES 1 and 4 for discussion of
significant changes to the Company's operations during 2000 that have impacted
quarterly operating results and may impact future operations (dollars in
thousands).
1ST QUARTER 2ND QUARTER 3RD QUARTER 4TH QUARTER
- ------------------------------------------------------------------------------------------------------------
YEAR ENDED DECEMBER 31, 2000
Interest income $142,829 $146,797 $145,980 $150,979
Interest and related expenses 130,214 136,771 136,317 138,848
-------- -------- -------- --------
Net margin on mortgage assets and other investments 12,615 10,026 9,663 12,131
Other operating revenue (expense)* (945) (94,278) 104 (802)
-------- -------- -------- --------
$ 11,670 $(84,252) $ 9,767 $ 11,329
======== ======== ======== ========
Net income per common share:
Basic $0.22 $(3.98) $0.15 $0.24
Diluted 0.22 (3.98) 0.15 0.21
Return on average stockholders' equity
and preferred stock subject to repurchase 6.96% (58.01)% 7.04% 8.18%
24
1ST QUARTER 2ND QUARTER 3RD QUARTER 4TH QUARTER
- ------------------------------------------------------------------------------------------------------------
YEAR ENDED DECEMBER 31, 1999
Interest income $124,342 $146,191 $147,817 $144,809
Interest and related expenses 112,058 128,764 132,511 131,614
-------- -------- -------- --------
Net margin on mortgage assets and other investments 12,284 17,427 15,306 13,195
Other operating revenue (expense) 1,623 (744) (784) (398)
-------- -------- -------- --------
$ 13,907 $ 16,683 $ 14,522 $ 12,797
======== ======== ======== ========
Net income per common share:
Basic $0.27 $0.38 $0.31 $0.25
Diluted 0.27 0.38 0.31 0.25
Return on average stockholders' equity
and preferred stock subject to repurchase 8.16% 9.88% 8.66% 7.57%
* Second quarter 2000 includes losses incurred restructuring the mortgage
investment portfolio in connection with modifying the Company's investment
strategy (see NOTES 1 and 4). Second quarter 2000 results also include $3.6
million of severance payments related to the settlement of obligations to
the Company's former Chairman and Chief Executive Officer and several other
employees.
NOTE 17 -- MARKET AND DIVIDEND INFORMATION (UNAUDITED)
The New York Stock Exchange trading symbol for the Company's common stock
is CMO. There were 3,568 holders of record of the Company's common stock at
December 31, 2000. In addition, depository companies held stock for 23,266
beneficial owners. The high and low stock sales prices and dividends declared on
common stock were as follows:
YEAR ENDED DECEMBER 31, 2000 YEAR ENDED DECEMBER 31, 1999
----------------------------------- -------------------------------
STOCK PRICES STOCK PRICES
---------------------- DIVIDENDS -------------------- DIVIDENDS
HIGH LOW DECLARED HIGH LOW DECLARED
------------------------------------------------------- -------------------------------
First quarter $ 9 1/8 $7 1/4 $0.22 $12 $ 8 $0.28
Second quarter 8 7/8 6 0.16 12 3/8 10 1/4 0.36
Third quarter 9 11/16 7 7/8 0.12 11 1/2 7 3/4 0.32
Fourth quarter 12 8 15/16 0.21 8 3/4 7 3/8 0.24
25
SELECTED FINANCIAL DATA
(In thousands, except percentages and per share amounts)
YEAR ENDED DECEMBER 31
------------------------------------------------------------------
2000 1999 1998 1997 1996
- -------------------------------------------------------------------------------------------------------------------------
SELECTED CONSOLIDATED STATEMENT
OF OPERATIONS DATA:
Interest income $ 586,585 $ 563,159 $ 667,198 $ 694,259 $ 662,964
Interest and related expense 542,150 504,947 659,575 616,287 589,606
---------- ---------- ---------- ----------- -----------
Net margin on mortgage assets and other
investments 44,435 58,212 7,623 77,972 73,358
Net margin on mortgage banking operations* - - 11,821 59,422 49,122
Other operating revenue (expense)** (95,921) (303) (254,208) 22,532 4,748
---------- ---------- ---------- ------------ -----------
Net income (loss) $ (51,486) $ 57,909 $ (234,764) $ 159,926 $ 127,228
========== ========== ========== =========== ===========
Net income (loss) per common share:***
Basic $ (3.30) $ 1.21 $ (8.44) $ 5.25 $ 4.74
Diluted (3.30) 1.21 (8.44) 4.70 4.14
Return on average stockholders' equity
and preferred stock subject to repurchase (8.72)% 8.56% (28.83)% 19.12% 18.41%
Cash dividends paid per share:
Common $ 0.71 $ 1.20 $ 2.00 $ 4.80 $ 4.23
$1.60 Series A Preferred 1.60 1.60 1.60 1.60 1.60
$1.26 Series B Preferred 1.26 1.26 1.26 1.26 1.26
$0.56 Series C Preferred 0.56 0.03 - - -
$0.40 Series D Preferred 0.30 0.02 - - -
Average number of common shares outstanding:***
Basic 22,973 29,174 30,474 25,629 19,158
Diluted 22,973 29,523 30,474 34,011 30,750
SELECTED CONSOLIDATED BALANCE SHEET DATA:
Mortgage securities and other investments $5,394,459 $5,408,714 $2,369,602 $ 6,114,130 $ 4,840,417
CMO collateral and investments 3,126,878 3,318,886 4,571,274 5,195,436 4,501,646
Mortgage servicing rights* - - - 669,062 626,094
Total assets 8,610,497 8,807,039 7,100,287 12,357,515 10,157,338
Borrowings under repurchase arrangements 4,904,632 4,872,392 1,839,868 7,099,706 5,462,856
Collateralized mortgage obligations 3,103,874 3,289,584 4,521,324 4,309,455 3,861,892
Preferred stock subject to repurchase 25,210 50,584 - - -
Stockholders' equity 545,669 563,806 680,201 888,608 726,869
NOTE: See "Management's Discussion and Analysis of Financial Condition" and
"Notes to Consolidated Financial Statements" for discussion of changes to
the Company's operations that are expected to impact future operating
results.
* The mortgage banking operations, including related mortgage servicing
rights, were sold in December 1998.
** Includes losses on the sale of mortgage assets incurred during the second
quarter of 2000 with the modification of the Company's investment strategy
to focus on short maturity and adjustable-rate mortgage assets. Results in
1998 include losses from the sale of mortgage assets, principally
interest-only mortgage securities.
*** Net income (loss) per common share and Average number of common shares
outstanding amounts prior to 1997 have been restated as required to comply
with Statement of Financial Accounting Standards No. 128, "Earnings per
Share." For further discussion of net income (loss) per common share, see
"Notes to Consolidated Financial Statements." Amounts have been adjusted
for a 1-for-2 reverse common stock split effective May 8, 2000.
26
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
FINANCIAL CONDITION
OVERVIEW
Capstead Mortgage Corporation, a mortgage investment firm operating as a
real estate investment trust ("REIT"), earns income from investing in mortgage
assets on a leveraged basis and from other investment strategies. With the
election of a new Board of Directors in April 2000, the Company modified its
investment strategy to focus on adjustable-rate and short-maturity assets,
including, but not limited to, adjustable-rate, single-family residential
mortgage-backed securities issued by government-sponsored entities, either
Fannie Mae, Freddie Mac or Ginnie Mae ("Agency Securities") and credit-sensitive
commercial and residential mortgage assets. By focusing on investments that
adjust to a more current interest rate within one to twelve months, this
investment strategy is intended to help preserve capital and stabilize earnings
prospects over the long term.
Fannie Mae, Freddie Mac and Ginnie Mae are also referred to as FNMA, FHLMC
and GNMA, respectively.
ELECTION OF NEW LEADERSHIP AND RELATIONSHIP WITH FORTRESS INVESTMENT GROUP LLC
In December 1999, the Company issued $51.2 million of Series C & D voting
preferred shares to an affiliate of Fortress Investment Group LLC (together with
its affiliates, "Fortress"). Fortress is a real estate investment firm with
experience in investing in a variety of asset types across the credit spectrum.
Together with its purchases of 3.9 million common shares, Fortress controlled
33% of the voting shares of the Company as of December 31, 2000. During the
fourth quarter of 2000, Fortress converted all of its Series D preferred shares
into 2.7 million common shares.
At the Company's April 2000 annual meeting, stockholders elected a new
seven member Board of Directors, including four members designated by Fortress.
Wesley R. Edens, chairman of the board of Fortress, was then appointed
Capstead's Chairman of the Board and Chief Executive Officer. The Company
compensates Fortress for the services of Mr. Edens and, as needed, other
individuals employed by Fortress pursuant to a management contract (see NOTE 14
to the accompanying consolidated financial statements for further information
regarding this arrangement).
1-FOR-2 REVERSE COMMON STOCK SPLIT
In April 2000, stockholders also approved a 1-for-2 reverse common stock
split that was effective the close of business on May 8, 2000. Concurrent with
the reverse split the conversion ratio for each series of preferred shares was
adjusted accordingly. All share and per share information presented has been
restated to reflect the reverse common stock split.
27
MORTGAGE SECURITIES AND OTHER INVESTMENTS
Mortgage securities and other investments consist primarily of high quality
single-family residential mortgage-backed securities, most of which are
adjustable-rate mortgage ("ARM") Agency Securities (see "NOTE 4" to the
accompanying consolidated financial statements for further discussion of how the
Company classifies its mortgage securities and other investments). Agency
Securities are AAA-rated and have no foreclosure risk. Non-agency securities
consist of private mortgage pass-through securities whereby the related credit
risk of the underlying loans is borne by AAA-rated private mortgage insurers and
other AAA-rated private mortgage securities (together, "Non-agency Securities").
The Company also invests in credit-sensitive commercial mortgage-backed
securities ("CMBS"). Although currently investment grade, these securities carry
credit risk associated with the underlying commercial mortgage loans. Features
of the related CMBS issuances, including subordinated securities held by other
investors, helps mitigate this risk (see "Risks Associated With Credit-Sensitive
Investments"). Mortgage securities and other investments are financed under
repurchase arrangements with investment banking firms pursuant to which the
portfolios are pledged as collateral (see "Liquidity and Capital Resources").
In connection with modifying its investment strategy in April 2000, the
Company sold $1.4 billion of fixed-rate and medium-term mortgage investments and
designated for sale nearly $700 million of primarily medium-term securities,
incurring a charge to operating results of $90.0 million. The charge consisted
of realized losses of $70.9 million and a $19.1 million reduction in the
Company's basis in securities designated for sale. During the third quarter,
another $100 million of fixed-rate Non-agency Securities were sold, further
reducing holdings of fixed-rate securities. With capital made available from
these sales and from $1.0 billion of portfolio runoff, the Company acquired $2.2
billion of ARM Agency Securities and $105 million of ARM Non-agency Securities
(through the redemption of 4 series of off-balance sheet collateralized mortgage
obligations ("CMOs") previously issued by the Company). Although up to this
point the Company has made only limited acquisitions of credit-sensitive
mortgage assets such as CMBS, it continues to evaluate other suitable
investments in keeping with its new investment strategy. These investments may
include credit-sensitive commercial and residential mortgage assets which, when
combined with the prudent use of leverage, can provide attractive returns.
Including the sale shortly after year-end of $442 million of medium-term
securities, the Company's mortgage investment portfolio stood at just under $5
billion entering 2001 consisting primarily of ARM Agency Securities. The future
size and composition of the Company's mortgage-related investments will depend
on market conditions, including levels of mortgage prepayments and the
availability of suitable investments at attractive pricing (see "Effects of
Interest Rate Changes").
28
The following yield and cost analysis illustrates results achieved during
the most recent quarter for each component of the Company's mortgage investment
portfolio and anticipated first quarter 2001 earnings capacity as first
projected by the Company on February 7, 2001 (the date the Company released its
fourth quarter 2000 results and based on interest rates in effect at that date)
(dollars in thousands):
4TH QUARTER AVERAGE AS OF DECEMBER 31, 2000 PROJECTED
------------------------------- ----------------------- 1ST LIFETIME
ACTUAL ACTUAL PREMIUMS QUARTER PREPAYMENT
BASIS YIELD/COST RUNOFF (DISCOUNTS) BASIS YIELD/COST ASSUMPTIONS
- -------------------------------------------------------------- ----------------------- -----------------------
(a) (a) (b) (b)
Agency Securities:
FNMA/FHLMC:
Fixed-rate $ 3,565 9.73% 21% $ 16 $ 3,427 9.73% 25%
Medium-term (c) 603,488 7.00 24 (5,357) 581,597 6.81 25
LIBOR/CMT ARMs 2,007,320 7.11 24 40,140 2,216,200 7.08 40
COFI ARMs 209,170 7.58 14 (4,957) 204,764 7.45 15
GNMA ARMs 2,265,104 6.92 18 18,323 2,200,281 6.94 24
---------- ---- --- ------- ----------- ----- --
5,088,647 7.03 21 48,165 5,206,269 7.02 31
Non-agency Securities 99,533 8.21 27 - 94,538 8.25 30
CMBS - adjustable-rate 74,975 9.35 5 (688) 74,232 8.47 -
--------- ---- --- ------- ----------- ----- --
5,263,155 7.09 21% $47,477 5,375,039 7.07 31%
=== ======= ==
Borrowings (4,817,809) (6.57) (4,904,632) (5.92)
---------- ----- ---------- -----
Capital employed/
financing spread $ 445,346 0.52% $ 470,407 1.15%
============ ==== =========== =====
Return on assets (d) 0.94% 1.72%
==== =====
(a) Basis represents the Company's investment before mark-to-market.
(b) Projected yields for the first quarter of 2001 reflect ARM coupon resets
and lifetime prepayment assumptions as adjusted for expected prepayments
for this quarter as of February 7, 2001 (the date the Company released
fourth quarter results and based on interest rates in effect at that
date). Actual yields realized in future periods will largely depend upon
(i) changes in portfolio composition, (ii) ARM coupon resets, (iii)
actual prepayments and (iv) any changes in lifetime prepayment
assumptions.
(c) In January 2001, the Company sold $442 million of medium-term securities
for a gain of $5.7 million. Projected first quarter yields are provided
for the reduced holdings of medium-term securities.
(d) The Company uses its liquidity to pay down borrowings. Return on assets
is calculated assuming the use of this liquidity to reduce borrowing
costs (see "Utilization of Capital and Liquidity").
Throughout 2000, overall portfolio yields benefited from increases in
yields on holdings of ARM securities as interest rates on the underlying
mortgage loans reset higher, reflecting a trend of increasing interest rates
that has been evident since the Federal Reserve began raising short-term
interest rates in June 1999 in response to inflation concerns. However, it now
appears that this trend may have reversed. The Federal Reserve announced
consecutive 50 basis point reductions in short-term interest rates on January 3
and again on January 31, 2001 due to concerns over economic weakness.
Consequently, yields on ARM securities are expected to peak in the first quarter
of 2001 and then begin declining. For example, if interest rates stabilize at
rates in effect February 7, 2001, yields on the Company's current holdings of
ARM securities are expected to decline approximately 55 basis points by
year-end. Actual yields on ARM securities will depend on fluctuations in, and
market expectations for fluctuations in, interest rates and levels of mortgage
prepayments (see "Effects of Interest Rate Changes").
29
The rate of principal prepayments on holdings of ARM securities is expected
to accelerate in future quarters, particularly if mortgage interest rates
continue to decline. Currently, coupon interest rates on most of the mortgage
loans underlying holdings of ARM securities are above prevailing fixed-rate
mortgage interest rates, which is expected to prompt higher levels of
prepayments until such time as the interest rates on these loans reset to lower
levels as discussed above. At December 31, 2000, the net premium on holdings of
ARM securities was $53.5 million, representing 1.17% of related unpaid principal
balances. While lower prepayment levels improve mortgage investment yields by
allowing related premiums to be recognized in operating results over a longer
period, higher prepayment levels shorten the period over which the premiums are
amortized thus reducing investment yields. Annualized prepayments on Fannie Mae
and Freddie Mac ARM securities averaged 23.5% for the fourth quarter of 2000,
slightly higher than the 22.4% annualized rate for the third quarter but similar
to the 23.4% level experienced in the fourth quarter of 1999. Annualized
prepayments on Ginnie Mae ARM securities averaged 18.4% in the fourth quarter of
2000, compared to 16.9% during the prior quarter and 18.0% for the same period
of 1999.
Average borrowing rates are expected to decline 65 basis points during the
first quarter of 2001 because of the January 2001 Federal Reserve rate
reductions. The full benefit of these rate reductions on the Company's borrowing
rates should be realized in the second quarter of 2001. Any further changes in
the Company's borrowing rates will depend on future actions by the Federal
Reserve to change short-term interest rates, market expectations of future
changes in short-term interest rates and the extent of any financial market
liquidity concerns (see "Effects of Interest Rate Changes").
To summarize, the Company anticipates improvement in financing spreads in
early 2001, with the potential for satisfactory net margins over the course of
the year, subject to the impact of fluctuations in, and market expectations for
fluctuations in, interest rates and levels of mortgage prepayments as well as
other factors including portfolio size and composition.
CMO COLLATERAL AND INVESTMENTS
Since exiting the residential mortgage loan conduit business in 1995,
Capstead has maintained finance subsidiaries with capacity to issue CMOs and
other securitizations backed by single-family residential mortgage loans
("securitization shelves"). From time to time, the Company purchases mortgage
loans from originators or conduits, places these loans into private mortgage
pass-through securities and issues CMOs or other securities backed by these
securities. The Company may or may not retain a significant residual economic
interest in these securitizations. During the first quarter of 2000, Capstead
issued one such CMO totaling $236 million. The Company did not retain any
significant residual economic interest in this issuance.
To date, the related credit risk of the securities collateralizing CMOs
issued by Capstead is borne by AAA-rated private mortgage insurers or by
subordinated bonds within the related CMO series to which the collateral is
pledged. The Company has only $799,000 of credit risk held in the form of
subordinated bonds associated with approximately $489 million of these
securities outstanding as of December 31, 2000. In addition, Capstead has
retained $2.8 million of reserve funds in connection with two 1993 mortgage loan
sales. These reserve funds are available to pay special hazard costs (e.g.
earthquake or mudslide-related losses) or certain bankruptcy costs associated
with approximately $128 million of loans
30
outstanding as of December 31, 2000 from the related securitizations. CMO
collateral and investments, net of related bonds, was $23.0 million at year-end,
down from $29.3 million at December 31, 1999. Included in this net investment
are $17.4 million of the remaining CMO collateral premiums and bond discounts.
Similar to premiums on the Company's mortgage investments, CMO collateral
premiums and bond discounts, along with most of remaining CMO investments, are
amortized to income as CMO collateral yield or bond expense adjustments based on
both actual prepayments and lifetime prepayment assumptions (see "Effects of
Interest Rate Changes").
SHARE REPURCHASES AND BOOK VALUES PER COMMON SHARE
Since share repurchases began in December 1998 through December 31, 2000,
the Company has repurchased 26.9% of its outstanding common shares and 8.4% of
its Series B preferred shares. During the year ended December 31, 2000, the
Company, through open market purchases, acquired 376,950 common shares at an
average price of $7.77 (including transaction costs) and 826,900 shares of its
$1.26 Cumulative Convertible Preferred Stock, Series B ("Series B preferred
shares") at an average price of $9.61 (including transaction costs). On January
25, 2000 the Company purchased 5,568,500 common shares at a price of $9.27 per
share (including transaction costs) pursuant to a tender offer that closed on
January 14, 2000.
As of December 31, 2000, the Company had remaining authorization to make
open market repurchases of 819,300 common shares and 551,100 Series B preferred
shares. On February 16, 2001 the Company commenced a tender offer to purchase up
to 5 million common shares at $12.75 per share. The offer is expected to be
completed by March 16, 2001, unless extended by the Company.
At December 31, 2000 book value per common share was $13.11, compared to
$11.83 per common share at December 31, 1999 (calculated assuming redemption of
the Series A and B preferred shares and conversion of preferred shares held by
Fortress). The increase in book value per common share reflects the positive
impact on the value of the mortgage investment portfolio of higher yields on ARM
securities and lower prevailing interest rates. Share repurchases also
contributed to higher book value. The market value of the mortgage investment
portfolio will continue to fluctuate with changes in interest rates and market
liquidity, among other factors, and such changes will be reflected in book value
per common share.
The recently announced tender offer is not expected to have a significant
impact on book value per common share, although remaining outstanding common
shares will participate to a greater extent in future operating results and
changes in the market value of Capstead's mortgage assets.
31
UTILIZATION OF CAPITAL AND LIQUIDITY
The Company's utilization of capital and potential liquidity as of
December 31, 2000 were as follows (in thousands):
CAPITAL
ASSETS BORROWINGS EMPLOYED LIQUIDITY
-------------------------------------------------------------------------------------------
Agency Securities:
FNMA/FHLMC:
Fixed-rate $ 3,646 $ - $ 3,646 $ 3,537
Medium-term 585,756 530,379 55,377 37,804
LIBOR/CMT ARMs 2,225,118 1,983,319 241,799 175,046
COFI ARMs 208,672 194,753 13,919 7,659
GNMA ARMs 2,199,649 2,126,437 73,212 7,222
---------- ---------- -------- --------
5,222,841 4,834,888 387,953 231,268
Non-agency Securities 96,390 6,947 89,443 84,624
CMBS - adjustable-rate 75,228 62,797 12,431 (677)
CMO collateral and investments 3,126,878 3,103,874 23,004 -
---------- ---------- -------- --------
$8,521,337 $8,008,506 512,831 315,215
========== ==========
Other assets, net of other liabilities 58,048 21,761**
-------- --------
$570,879 $336,976
======== ========
* Based on maximum borrowings available under existing uncommitted repurchase
arrangements considering the fair value of related collateral as of
December 31, 2000 (see "Liquidity and Capital Resources").
** Represents unrestricted cash and cash equivalents (see NOTE 2).
The Company finances its investments in mortgage securities with investment
banking firms under repurchase arrangements (see "Liquidity and Capital
Resources"). CMO collateral and investments are generally pledged to secure CMO
bonds. Liquidity is affected by, among other things, changes in market value of
securities pledged under repurchase arrangements, principal prepayments and
general conditions in the mortgage finance industry.
32
RESULTS OF OPERATIONS
Comparative net operating results (interest income or fee revenue, net of
related interest expense and, in the case of CMO administration, related direct
and indirect operating expense) by source were as follows (in thousands, except
per share amounts):
YEAR ENDED DECEMBER 31
---------------------------------
2000 1999 1998
--------------------------------------------------------------------------------------
Agency Securities $36,626 $52,514 $ 12,754
Non-agency Securities 6,900 8,043 4,947
CMBS 2,350 37 -
CMO collateral and investments (1,441) (2,382) (10,078)
-------- ------- ---------
Net margin on mortgage assets 44,435 58,212 7,623
Mortgage banking operations - - 11,821
Other revenue (expense):
Gain (loss) on sale of mortgage assets and
related derivative financial instruments (70,173) 1,738 (245,261)
Impairment on mortgage assets (19,088) - (4,051)
Severance charges (3,607) - -
CMO administration and other 3,484 4,083 4,598
Other operating expense (6,537) (6,124) (9,494)
-------- ------- ---------
Net income (loss) $(51,486) $57,909 $(234,764)
======== ======= =========
Basic and diluted net income (loss) per
common share $(3.30) $1.21 $(8.44)
2000 COMPARED TO 1999
The earning capacity of Capstead's mortgage asset portfolios is largely
dependent on the overall size and composition of the portfolios, the
relationship between short- and long-term interest rates (the "yield curve") and
the extent the Company continues to invest its liquidity in these portfolios.
Lower overall net margins on mortgage assets for the year ended December 31,
2000 compared to 1999 reflect higher borrowing costs incurred financing the
Company's mortgage investments. These borrowing costs were higher during 2000
primarily because of actions taken by the Federal Reserve to increase short-term
interest rates by a total of 175 basis points beginning in June 1999 and
culminating in a 50 basis point increase in May 2000. As a result, rates on
borrowings under repurchase arrangements averaged 115 basis points higher in
2000 compared to 1999. These higher borrowing rates were only partially offset
by the benefits of improving yields on ARM securities, the restructuring of the
Company's mortgage investment portfolio as a result of modifying its investment
strategy and relatively low mortgage asset prepayment levels. See above
"Financial Condition - Mortgage Securities and Other Investments" for a
forward-looking discussion of the effects of recent actions taken by the Federal
Reserve to lower short-term interest rates.
Agency Securities contributed less to operating results during 2000 than in
1999 because of higher borrowing costs, despite higher average yields. Yields
for this portfolio averaged 6.59% during the year, compared to 5.81% in 1999,
while average borrowing rates were 6.30% compared to 5.16% in 1999. Average
yields increased with the restructuring-related sale of relatively low-coupon
fixed-rate and medium-term securities. Yields also benefited from higher yields
on newly acquired ARM securities and on mortgage securities designated
33
for sale in connection with the portfolio restructuring. In addition, yields
benefited as interest rates on mortgage loans underlying ARM securities reset
higher (reflecting higher interest rates resulting from the Federal Reserve rate
increases discussed above) and prepayment rates remained at relatively low
levels. The average outstanding Agency Securities portfolio was $5.0 billion
during 2000, compared to $4.9 billion in 1999.
Non-agency Securities contributed less to operating results during 2000
despite a higher average outstanding portfolio because of higher borrowing
costs. The average outstanding portfolio was $152 million during 2000 compared
to $120 million in 1999. During 2000, the Company financed this portfolio with
average borrowings of $80 million, while in 1999 the portfolio was funded almost
entirely with equity until late in the year. Average yields for this portfolio
(calculated including mortgage insurance costs) were 7.98% during 2000, compared
to 8.06% in 1999.
Capstead made its first acquisitions of credit-sensitive CMBS in December
1999 and made only modest additions to this portfolio in early 2000. The
portfolio currently consists of $75 million of adjustable-rate CMBS financed by
longer-term repurchase arrangements. These investments yielded 9.07% during the
year while average borrowing rates were 6.94%.
CMO collateral and investments results benefited from lower prepayment
rates during 2000 than in 1999 allowing remaining collateral premiums and bond
discounts to be amortized to earnings over a longer period. In addition, results
for the prior year included the write-off of bond discounts related to 1999
redemptions of CMO bonds. Without the issuance of CMOs in which the Company
retains residual interests, or the acquisition of other CMO investments, this
portfolio is not expected to provide a positive return on capital employed in
future periods.
In April, the Company incurred a $90.0 million charge to operating results
for the sale, or designation for sale, of most of its fixed-rate and medium-term
securities. This charge consisted of realized losses of $70.9 million and a
$19.1 million reduction in basis in securities designated for sale. In addition,
during the second quarter, the Company incurred severance charges of $3.6
million, related primarily to the resignation of its former chief executive
officer. Gain (loss) on sale of mortgage assets also includes a gain on the
subsequent sale of $100 million of fixed-rate Non-agency Securities.
CMO administration and other revenue was lower this year primarily because
a declining portfolio of CMOs for which the Company provides administrative
services. As these CMOs pay down, related fee income is expected to decline.
Other operating expenses were fairly stable year to year but may increase
in future periods with the adoption of a new management incentive program in
early 2001.
1999 COMPARED TO 1998
Operating results for the year ended December 31, 1999 were substantially
improved over 1998 results. The Company entered 1999 with substantial liquidity
after having sold a substantial portion of its mortgage assets, including a $1.0
billion interest-only securities portfolio in June 1998 and its mortgage banking
operations in December 1998. This liquidity was initially employed to reduce
borrowings, which benefited net margins on the Company's mortgage asset
portfolios. Margins also benefited from early 1999 acquisitions of Agency
Securities, slower prepayments and lower borrowing rates during the first half
of the year. In 1998, the Company incurred substantial losses from asset sales
and from recording write-offs of premiums and CMO bond discounts and impairment
charges on CMO investments
34
attributable to high levels of prepayments and the expectation at that time that
such prepayment levels would continue.
Agency Securities contributed more to operating results during 1999 than
Agency and U.S. Treasury Securities contributed during 1998 due primarily to
having employed significantly more capital to this portfolio that lowered
borrowing costs. In addition, during most of 1999, the Company enjoyed improved
financing spreads over those achieved in 1998. On average, the Company employed
$463 million of its capital to this portfolio during 1999 compared to only $108
million in 1998. Yields for this portfolio were 5.81% during 1999 compared to
5.77% in 1998, while borrowing rates, although significantly higher by year-end,
averaged 5.16% during 1999 compared to 5.54% in 1998. Yields in 1999 benefited
from lower prepayments and changes in portfolio mix including the sale of
relatively low-yielding U.S. Treasury notes held in 1998. In addition, during
1998 rapidly declining mortgage interest rates significantly increased
prepayments and prepayment risk, resulting in premium amortization adjustments,
which depressed yields.
Non-agency Securities contributed more to operating results during 1999
despite a lower average outstanding portfolio because the Company funded this
portfolio entirely with its equity for most of the year. The average outstanding
portfolio was $120 million during 1999, compared to $496 million in 1998 during
which time significantly less capital was employed supporting this portfolio.
Average yields for this portfolio (calculated including mortgage insurance
costs) were 8.06% during 1999, compared to 6.79% in 1998.
CMO collateral and investments operating results during 1999 were improved
over 1998 results primarily because of lower prepayments in 1999. In 1998,
rapidly declining mortgage interest rates significantly increased prepayments
and prepayment risk resulting in write-offs of CMO bond discounts.
The gain on sale of mortgage assets recorded in 1999 related primarily to
the first quarter sale of remaining purchased interest-only mortgage securities
earlier in the year.
Operating expenses during 1999 reflect lower costs of operating only the
mortgage investment business after the December 1998 sale of the mortgage
banking operations.
LIQUIDITY AND CAPITAL RESOURCES
The Company's primary sources of funds include borrowings under repurchase
arrangements, monthly principal and interest payments on mortgage securities and
other investments, excess cash flows on CMO collateral and investments and
proceeds from sales of mortgage assets (see "Financial Condition - Utilization
of Capital and Liquidity"). The Company currently believes that these funds are
sufficient for the acquisition of mortgage assets, repayments on borrowings, the
payment of cash dividends as required for Capstead's continued qualification as
a REIT and common and preferred share repurchases, if any. It is the Company's
policy to remain strongly capitalized and conservatively leveraged.
Borrowings under repurchase arrangements secured by Agency Securities and
Non-agency Securities generally have maturities of less than 31 days. The
Company has uncommitted repurchase facilities with investment banking firms to
finance these mortgage
35
assets, subject to certain conditions. Interest rates on borrowings under these
facilities are generally based on overnight to 30-day London Interbank Offered
Rate ("LIBOR") rates. The terms and conditions of these arrangements are
negotiated on a transaction-by-transaction basis. Amounts available to be
borrowed under these arrangements are dependent upon the fair value of the
securities pledged as collateral, which fluctuates with changes in interest
rates and the securities' credit quality.
Borrowings under repurchase arrangements secured by purchases of
adjustable-rate CMBS more closely match the interest rate adjustment features
and expected life of these investments such that the Company anticipates it can
earn more consistent net interest spreads on these investments and, as a result,
experience less interest rate volatility than experienced with the Company's
other mortgage investments. Should Capstead make significant additional
investments in credit-sensitive mortgage assets, it is anticipated that the
Company will attempt to lessen interest rate volatility in a similar fashion or
through the use of derivative financial instruments ("Derivatives") such as
interest rate swaps (see "Effects of Interest Rate Changes" and "Risks
Associated With Credit-Sensitive Investments").
EFFECTS OF INTEREST RATE CHANGES
INTEREST RATE SENSITIVITY ON OPERATING RESULTS
The Company performs earnings sensitivity analysis using an income
simulation model to estimate the effects that specific interest rate changes
will have on future earnings. All mortgage assets and Derivatives held, if any,
are included in this analysis. The sensitivity of CMO administration fee income
to changes in interest rates is included as well. The model incorporates
management assumptions regarding the level of prepayments on mortgage assets for
a given interest rate change using industry estimates of prepayment speeds for
various coupon segments. These assumptions are developed through a combination
of historical analysis and future expected pricing behavior. Because the Company
modified its investment strategy during 2000 to focus on short maturity and
adjustable-rate mortgage assets, earnings were less sensitive to changes in
interest rates at December 31, 2000 than the previous year-end, as indicated
below (dollars in thousands):
10-YEAR
30-DAY U.S.
LIBOR TREASURY
RATE RATE IMMEDIATE CHANGE IN:*
- ----------------------------------------------- -------------------------------------------------
30-day LIBOR rate Down 1.00% Down 1.00% Flat Up 1.00%
10-year U.S. Treasury rate Down 1.00% Flat Up 1.00% Up 1.00%
Projected 12-month
earnings change:**
December 31, 2000 6.56% 5.12% $18,344 $23,447 $4,145 $(22,665)
December 31, 1999 5.82 6.44 31,160 36,190 5,044 (37,821)
* Sensitivity of earnings to changes in interest rates is determined relative
to the actual rates at the applicable date.
** Note that the projected 12-month earnings change is predicated on
acquisitions of similar assets sufficient to replace runoff only and
excludes $442 million of medium-term securities sold in early 2001. There
can be no guarantee that suitable investments will be available for
purchase at attractive prices or if investments made will behave in the
same fashion as assets currently held.
36
Income simulation modeling is a primary tool used to assess the direction
and magnitude of changes in net margins on mortgage assets resulting from
changes in interest rates. Key assumptions in the model include prepayment rates
on mortgage assets, changes in market conditions, and management's financial
capital plans. These assumptions are inherently uncertain and, as a result, the
model cannot precisely estimate net margins or precisely predict the impact of
higher or lower interest rates on net margins. Actual results will differ from
simulated results due to timing, magnitude and frequency of interest rate
changes and other changes in market conditions, management strategies and other
factors.
GENERAL DISCUSSION OF EFFECTS OF INTEREST RATE CHANGES
Changes in interest rates may affect the Company's earnings in various
ways. Earnings currently depend, in part, on the difference between the interest
received on mortgage securities and other investments, and the interest paid on
related borrowings, which are generally based on 30-day LIBOR. The resulting
spread may be reduced or even turn negative in a rising short-term interest rate
environment. Because the mortgage investment portfolio consists primarily of ARM
mortgage securities, the risk of rising short-term interest rates is offset to
some extent by increases in the rates of interest earned on the underlying ARM
loans, which reset periodically based on underlying indices (generally 1-year
CMT rates). Since ARM loans generally limit the amount of such increases during
any single interest rate adjustment period and over the life of the loan,
interest rates on borrowings can rise to levels that may exceed the interest
rates on the underlying loans contributing to lower or even negative financing
spreads. At other times, as seen in 1998, and to some extent, as is currently
anticipated in 2001, declines in these indices during periods of falling
short-term interest rates will negatively effect yields on ARM securities as the
underlying ARM loans reset at lower rates. If declines in these indices exceed
declines in the Company's borrowing rates, financing spreads could be lower or
even become negative. The Company may invest in Derivatives from time to time as
a hedge against rising interest rates on a portion of its short-term borrowings.
At December 31, 2000 the Company did not own any Derivatives as a hedge against
rising short-term interest rates.
Another effect of changes in interest rates is that as long-term interest
rates decrease, the rate of principal prepayments on mortgage loans underlying
mortgage investments generally increases. As seen in 1998, prolonged periods of
high prepayments can significantly reduce the expected life of mortgage
investments; therefore, the actual yields realized can be lower due to faster
amortization of premiums. Further, to the extent the proceeds of prepayments on
mortgage investments cannot be reinvested at a rate of interest at least equal
to the rate previously earned on such investments; earnings may be adversely
affected.
A change in interest rates also impacts earnings recognized from CMO
collateral and investments, which currently consist primarily of fixed-rate CMO
residuals (see "Financial Condition"). As seen in 1998, if mortgage interest
rates fall, prepayments on the underlying mortgage loans generally will be
higher, accelerating the amortization of collateral premiums and bond discounts.
Conversely, if mortgage interest rates rise significantly above interest rates
on the collateral, principal prepayments will typically diminish, improving the
overall return on an investment in a fixed-rate CMO residual because of an
increase in time over which the Company receives positive net cash flows and can
amortize remaining collateral premiums and bond discounts.
37
Capstead periodically sells mortgage assets, which may increase income
volatility because of the recognition of transactional gains or losses. Such
sales may become attractive as values of mortgage assets fluctuate with changes
in interest rates. At other times, such as in the second quarter of 2000, asset
sales may become prudent to shift the Company's investment focus.
RISKS ASSOCIATED WITH CREDIT-SENSITIVE INVESTMENTS
Commercial mortgage assets may be viewed as exposing an investor to greater
risk of loss than residential mortgage assets since such assets are typically
secured by larger loans to fewer obligors than residential mortgage assets.
Commercial property values and related net operating income are often subject to
volatility, and such net operating income may be sufficient or insufficient to
cover debt service on the related mortgage loan at any given time. The repayment
of loans secured by income-producing properties is typically dependent upon the
successful operation of the related real estate project and the ability of the
applicable property to produce net operating income rather than upon the
liquidation value of the underlying real estate. Even when the current net
operating income is sufficient to cover debt service, there can be no assurance
that this will continue to be the case in the future.
Additionally, commercial properties may not be readily convertible to
alternative uses if such properties were to become unprofitable due to
competition, age of improvements, decreased demand, regulatory changes or other
factors. The conversion of commercial properties to alternate uses often
requires substantial capital expenditures, which may or may not be available.
The availability of credit for commercial mortgage loans may be dependent
upon economic conditions in the markets where such properties are located, as
well as the willingness and ability of lenders to make such loans. The
availability of funds in the credit markets fluctuates and there can be no
assurance that the availability of such funds will increase above, or will not
contract below current levels. In addition, the availability of similar
commercial properties, and the competition for available credit, may affect the
ability of potential purchasers to obtain financing for the acquisition of
properties. This could effect the repayment of commercial mortgages.
Credit-sensitive residential mortgage assets differ from commercial
mortgage assets in several important ways, yet can still carry substantial
credit risk. Residential mortgage securities typically are secured by smaller
loans to more obligors than CMBS, thus spreading the risk of mortgagor default.
However, most of the mortgages supporting these securities are made to
homeowners that do not qualify for Agency loan programs for reasons including
loan size, financial condition, or work or credit history that may be indicative
of higher risk of default than loans qualifying for such programs. As with
commercial mortgage assets, in instances of default the Company may incur losses
if proceeds from sales of the underlying collateral are less than the unpaid
principal balances of the mortgage loans and related foreclosure costs. However,
with residential mortgage assets this risk may be mitigated by various forms of
credit enhancements including, but not limited to, primary mortgage insurance.
Through the process of securitizing both commercial and residential
mortgage assets, credit risk can be heightened or minimized. Senior classes in
multi-class securitizations generally have first priority over cash flows from a
pool of mortgages and, as a result, carry
38
the least risk, highest investment ratings and the lowest yields. Typically, a
securitization will also have mezzanine classes and subordinated classes.
Mezzanine classes will generally have somewhat lower credit ratings and may have
average lives that are longer than the senior classes. Subordinate classes are
junior in the right to receive cash flow from the underlying mortgages, thus
providing credit enhancement to the senior and mezzanine classes. As a result,
subordinated securities will have lower credit ratings because of the elevated
risk of credit loss inherent in these securities.
The availability of capital from external sources to finance investments in
credit-sensitive commercial and residential mortgage assets that are not
financed to maturity at acquisition may be diminished during periods of mortgage
finance market illiquidity, such as was experienced in 1998. Additionally, if
market conditions deteriorate resulting in substantial declines in value of
these assets, sufficient capital may not be available to support the continued
ownership of such investments, requiring these assets to be sold at a loss.
OTHER
FORWARD LOOKING STATEMENTS
This document contains "forward-looking statements" (within the meaning of
the Private Securities Litigation Reform Act of 1995) that inherently involve
risks and uncertainties. The Company's actual results and liquidity can differ
materially from those anticipated in these forward-looking statements because of
changes in the level and composition of the Company's investments and unforeseen
factors. These factors may include, but are not limited to, changes in general
economic conditions, the availability of suitable investments, fluctuations in,
and market expectations for fluctuations in, interest rates and levels of
mortgage prepayments, deterioration in credit quality and ratings, the
effectiveness of risk management strategies, the impact of leverage, liquidity
of secondary markets and credit markets, increases in costs and other general
competitive factors.