EXHIBIT 13
CAPSTEAD MORTGAGE CORPORATION
PORTIONS OF THE
ANNUAL REPORT TO STOCKHOLDERS
FOR THE YEAR ENDED DECEMBER 31, 2001
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, 2001 and 2000, 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, 2001. 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, 2001 and 2000, and the consolidated results
of its operations and its cash flows for each of the three years in the period
ended December 31, 2001, in conformity with accounting principles generally
accepted in the United States.
/s/ ERNST & YOUNG LLP
Dallas, Texas
January 25, 2002
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
<Table>
<Caption>
YEAR ENDED DECEMBER 31
------------------------------------------
2001 2000 1999
---------- ---------- ----------
INTEREST INCOME:
Mortgage securities and other investments $ 274,480 $ 349,533 $ 293,841
CMO collateral and investments 198,216 237,052 269,318
---------- ---------- ----------
Total interest income 472,696 586,585 563,159
---------- ---------- ----------
INTEREST AND RELATED EXPENSE:
Borrowings under repurchase arrangements 164,422 303,126 232,852
CMO borrowings 197,905 237,479 270,081
Mortgage insurance and other 990 1,545 2,014
---------- ---------- ----------
Total interest and related expense 363,317 542,150 504,947
---------- ---------- ----------
Net margin on mortgage assets and other investments 109,379 44,435 58,212
---------- ---------- ----------
OTHER REVENUE (EXPENSE):
Gain (loss) on sale of mortgage assets 7,956 (70,173) 1,738
Impairment on mortgage assets -- (19,088) --
Severance costs -- (3,607) --
CMO administration and other 3,705 3,484 4,083
Management and affiliate incentive fee (9,422) (389) (295)
Other operating expense (5,342) (6,148) (5,829)
---------- ---------- ----------
Total other revenue (expense) (3,103) (95,921) (303)
---------- ---------- ----------
NET INCOME (LOSS) $ 106,276 $ (51,486) $ 57,909
========== ========== ==========
Net income (loss) $ 106,276 $ (51,486) $ 57,909
Less preferred share dividends (20,446) (24,260) (22,556)
---------- ---------- ----------
Net income (loss) available to common stockholders $ 85,830 $ (75,746) $ 35,353
========== ========== ==========
Net income (loss) per common share:
Basic $ 6.43 $ (6.59) $ 2.42
Diluted 5.68 (6.59) 2.42
</Table>
See accompanying notes to consolidated financial statements.
CONSOLIDATED BALANCE SHEETS
(In thousands, except per share amounts)
<Table>
<Caption>
DECEMBER 31
------------------------------
2001 2000
------------ ------------
ASSETS
Mortgage securities and other investments
($3.3 billion pledged under repurchase arrangements) $ 3,455,219 $ 5,394,459
CMO collateral and investments 2,262,305 3,126,878
------------ ------------
5,717,524 8,521,337
Prepaids, receivables and other 54,381 67,399
Cash and cash equivalents 123,520 21,761
------------ ------------
$ 5,895,425 $ 8,610,497
============ ============
LIABILITIES
Borrowings under repurchase arrangements $ 3,207,068 $ 4,904,632
Collateralized mortgage obligations ("CMOs") 2,245,015 3,103,874
Incentive fee payable to management and affiliate 9,422 --
Accounts payable and accrued expenses 29,192 31,112
------------ ------------
5,490,697 8,039,618
------------ ------------
PREFERRED STOCK SUBJECT TO REPURCHASE
$0.56 Cumulative Convertible Preferred Stock, Series C, $0.10 par value;
-0- and 5,378 shares authorized, issued and outstanding at December 31,
2001 and 2000, respectively (converted to common shares May 4, 2001) -- 25,210
------------ ------------
STOCKHOLDERS' EQUITY
Preferred stock - $0.10 par value; 100,000 and 94,622 shares authorized,
respectively:
$1.60 Cumulative Preferred Stock, Series A, 273 and 374 shares issued
and outstanding at December 31, 2001 and 2000, respectively
($4,481 aggregate liquidation preference) 3,821 5,228
$1.26 Cumulative Convertible Preferred Stock, Series B,
15,842 and 15,845 shares issued and outstanding at
December 31, 2001 and 2000, respectively
($180,283 aggregate liquidation preference) 176,961 177,012
Common stock - $0.01 par value; 100,000 shares authorized;
13,862 and 12,641 shares issued and outstanding at
December 31, 2001 and 2000, respectively 139 126
Paid-in capital 559,571 740,740
Accumulated deficit (387,718) (396,882)
Accumulated other comprehensive income 51,954 19,445
------------ ------------
404,728 545,669
------------ ------------
$ 5,895,425 $ 8,610,497
============ ============
</Table>
See accompanying notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND
PREFERRED STOCK SUBJECT TO REPURCHASE
(In thousands, except per share amounts)
<Table>
<Caption>
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, 1999 $ -- $ 198,424 $ 151 $ 788,131 $ (305,287) $ (1,218) $ 680,201
Net income -- -- -- -- 57,909 -- 57,909
Other comprehensive loss -- -- -- -- -- (92,070) (92,070)
Cash dividends:
Common ($2.40 per share) -- -- -- -- (34,634) -- (34,634)
Preferred -- -- -- -- (22,305) -- (22,305)
Additions to capital 50,584 -- -- -- -- -- --
Capital stock repurchases -- (6,948) (9) (18,087) (251) -- (25,295)
---------- --------- ------ --------- ----------- ------------- -------------
BALANCE AT DECEMBER 31, 1999 50,584 191,476 142 770,044 (304,568) (93,288) 563,806
Net loss -- -- -- -- (51,486) -- (51,486)
Other comprehensive income -- -- -- -- -- 112,733 112,733
Cash dividends:
Common ($1.42 per share) -- -- -- -- (16,568) -- (16,568)
Preferred -- -- -- -- (25,546) -- (25,546)
Conversion of preferred stock (25,210) -- 13 25,197 -- -- 25,210
Additions to capital (164) -- 1 144 -- -- 145
Capital stock repurchases -- (9,236) (30) (54,645) 1,286 -- (62,625)
---------- --------- ------ --------- ----------- ------------- -------------
BALANCE AT DECEMBER 31, 2000 25,210 182,240 126 740,740 (396,882) 19,445 545,669
Net income -- -- -- -- 106,276 -- 106,276
Other comprehensive income:
Unrealized gain on cash flow
hedges, net -- -- -- -- -- 941 941
Unrealized gain on debt
securities, net -- -- -- -- -- 31,568 31,568
-------------
Total comprehensive income 138,785
Cash dividends:
Common - regular
($5.54 per share) -- -- -- -- (76,666) -- (76,666)
Common - special
($14.60 per share) -- -- -- (201,236) -- -- (201,236)
Preferred -- -- -- -- (20,446) -- (20,446)
Conversion of preferred stock (25,210) (1,458) 14 26,654 -- -- 25,210
Additions to capital -- -- 1 731 -- -- 732
Capital stock repurchases -- -- (2) (7,318) -- -- (7,320)
---------- --------- ------ --------- ----------- ------------- -------------
BALANCE AT DECEMBER 31, 2001 $ -- $ 180,782 $ 139 $ 559,571 $ (387,718) $ 51,954 $ 404,728
========== ========= ====== ========= =========== ============= =============
</Table>
See accompanying notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
<Table>
<Caption>
YEAR ENDED DECEMBER 31
------------------------------------------------
2001 2000 1999
------------ ------------ ------------
OPERATING ACTIVITIES:
Net income (loss) $ 106,276 $ (51,486) $ 57,909
Noncash items:
Amortization of discount and premium 31,263 17,486 40,020
Depreciation and other amortization 1,223 986 1,043
Impairment on mortgage assets -- 19,088 --
Loss (gain) on sale of mortgage assets (7,956) 70,173 (1,738)
Change in incentive fee payable to management and affiliate 9,422 -- --
Net change in prepaids, receivables, other assets, accounts payable
and accrued expenses 11,872 (3,371) 10,693
------------ ------------ ------------
Net cash provided by operating activities 152,100 52,876 107,927
------------ ------------ ------------
INVESTING ACTIVITIES:
Purchases of mortgage securities and other investments (226,557) (2,366,925) (4,380,781)
Purchases of CMO collateral and investments -- (235,999) --
Principal collections on mortgage investments 1,705,893 982,118 1,247,027
Proceeds from sales of mortgage assets 576,554 1,404,321 127,358
CMO collateral:
Principal collections 758,423 423,487 1,079,961
Decrease in accrued interest receivable 5,347 2,703 7,900
Decrease in short-term investments 461 269 14,119
------------ ------------ ------------
Net cash provided by (used in) investing activities 2,820,121 209,974 (1,904,416)
------------ ------------ ------------
FINANCING ACTIVITIES:
Increase (decrease) in short-term borrowings (1,697,564) 32,240 3,032,524
CMO borrowings:
Issuance of securities -- 235,999 --
Principal payments on securities (862,311) (430,705) (1,241,769)
Decrease in accrued interest payable (5,515) (2,245) (7,513)
Capital stock transactions (207,960) (62,752) 25,289
Dividends paid (97,112) (42,114) (56,939)
------------ ------------ ------------
Net cash provided by (used in) financing activities (2,870,462) (269,577) 1,751,592
------------ ------------ ------------
Net change in cash and cash equivalents 101,759 (6,727) (44,897)
Cash and cash equivalents at beginning of year 21,761 28,488 73,385
------------ ------------ ------------
Cash and cash equivalents at end of year $ 123,520 $ 21,761 $ 28,488
============ ============ ============
</Table>
See accompanying notes to consolidated financial statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2001
NOTE 1 -- BUSINESS
Capstead Mortgage Corporation operates as a real estate investment trust
("REIT") earning income from investing in real estate-related assets on a
leveraged basis and from other investment strategies. These investments
currently include, but are 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"). Capstead has
also made limited investments in credit-sensitive commercial mortgage assets.
The Company continues to evaluate suitable real estate-related investments,
which may include more credit-sensitive assets that can earn attractive returns
due largely to a higher risk of default and reduced liquidity compared to Agency
Securities. Capstead believes that such investments, when combined with the
prudent use of leverage, can provide attractive returns over the long term with
less sensitivity to changes in interest rates. Capstead's portfolios declined
during 2001 primarily because of high levels of mortgage prepayments. To the
extent proceeds of runoff or asset sales are not reinvested, or cannot be
reinvested, at a rate of return at least equal to the rate previously earned on
that capital, earnings may decline. The future size and composition of
Capstead's investment portfolios will depend on market conditions, including
levels of mortgage prepayments and the availability on a timely basis of
suitable investments at attractive pricing.
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 accounting principles generally accepted in the United
States. The amortization of premiums and discounts on mortgage assets and CMOs
is based on estimates of future prepayments on underlying mortgage loans, which
are impacted by future changes in interest rates and other factors beyond the
control of management. Actual results could differ from those estimates, which
could adversely affect profitability.
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 of fair value as of the balance sheet dates 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, which would affect Accumulated other
comprehensive income (loss) in stockholders' equity and the calculation of the
Management and affiliate incentive fee.
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 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 asset. Realized gains (losses) are included in Other revenue
(expense). The cost of assets sold is based on the specific identification
method. Unrealized gains (losses) are not amortized to income; however, if a
decline in fair value of an individual asset below amortized cost basis occurs
that is determined to be other than temporary, the difference between amortized
cost and fair value is included in Other revenue (expense) as an impairment
charge.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents include cash on hand and highly liquid
investments with original maturities of three months or less when purchased.
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
marketplace that are compatible with the Company's risk management objectives.
The Company has made limited use of Derivatives during the three years ended
December 31, 2001.
Statement of Financial Accounting Standards No. 133, "Accounting for
Derivative Instruments and Hedging Activities" ("SFAS 133") established new
accounting and reporting standards for Derivatives and hedging activities. This
includes the recognition of all Derivatives, including certain Derivatives not
previously afforded accounting recognition, as either assets or liabilities on
the balance sheets and measurement of those instruments at fair value. The
Company adopted this statement January 1, 2001 and recognized in Other
comprehensive income as cash flow hedge instruments certain call rights on
securitizations previously issued by the Company that were originally accounted
for as sales. These call rights allow Capstead to acquire, at its option, a
modest amount of adjustable-rate mortgage-backed securities at par value,
provided certain requirements specified in the related indentures have been met.
The fair value of these call rights is based on the discounted fair value
of the underlying loans in excess of par, less transaction costs. As such,
changes in the value of the call rights are 100% correlated to changes in value
of the underlying loans, excluding the effects of time value. Changes in time
value are recorded in Other revenue. Upon exercise, the underlying loans are
recorded at par. The remaining value of the related call right is reclassified
as a loan premium and is subsequently amortized to Interest income as a yield
adjustment. The related amount recorded in Other comprehensive income is also
amortized to Interest income concurrently with the loan premium resulting in a
zero net effect on income. Similarly, if the underlying loans are subsequently
sold, these amounts would be factored into the resulting gain or loss. If it is
concluded that exercise of a call right is not likely to occur, the related
amount carried in Other comprehensive income would be written off in Other
revenue.
BORROWINGS
CMOs, borrowings under repurchase arrangements and other borrowings, if
any, are carried at their unpaid principal balances, net of unamortized discount
or premium. Any discount or premium is recognized as an adjustment to Interest
and related expense by the interest method over the expected term of the related
borrowings.
INCOME TAXES
Income taxes are accounted for using the liability method, and deferred
income tax assets and liabilities are determined based on differences between
the 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.
MANAGEMENT AND AFFILIATE INCENTIVE FEE
Members of management, employees and an affiliate of Fortress Investment
Group LLC participate in an incentive compensation program established by the
members of the Board of Directors that are independent of Fortress Investment
Group LLC and its affiliates (together, referred to as "Fortress"). Fortress is
the Company's controlling stockholder, and its chairman of the board is also
Capstead's Chairman of the Board and Chief Executive Officer. Under the terms of
the program, incentive fee amounts are determined based on a 10%
participation in the `modified total return' of Capstead in excess of a 10%
benchmark return, multiplied by the Company's beginning `modified common book
value.' Modified total return under the program is measured as the change in
modified common book value per share during the year, together with common
dividends per share. Modified common book value is determined by deducting from
total equity the recorded value of preferred equity and unrealized losses on
assets classified as held-to-maturity, and adding back incentive fee accruals.
STOCK-BASED COMPENSATION
Compensation cost for stock-based awards for employees and directors is
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 in Other operating expense as the awards vest and restrictions
lapse.
RECLASSIFICATIONS, REVERSE COMMON STOCK SPLIT AND SPECIAL COMMON DIVIDEND
Certain amounts for prior years have been reclassified to conform to the
current year presentation. All references to common shares and per common share
amounts have been adjusted to reflect a 1-for-2 reverse common stock split,
which was approved at a special meeting of stockholders held June 15, 2001. The
common shares commenced trading on a post-reverse split basis on July 2, 2001,
coinciding with the first day the common shares traded ex-dividend for a $14.60
special common dividend paid June 29, 2001. The special common dividend, which
significantly reduced common equity capital relative to total equity capital,
was recorded as a reduction in Paid-in capital.
As a consequence of the special common dividend and the reverse split, the
conversion ratio for each series of preferred shares was adjusted July 2, 2001
in accordance with the terms of the governing Articles Supplementary, as
follows:
<Table>
<Caption>
PREFERRED SHARES PRIOR RATES CURRENT RATES
---------------- ----------- -------------
Series A 1.1049 0.9657
Series B 0.3844 0.3559
</Table>
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 and common share equivalents
outstanding, giving effect to dilutive stock options and dilutive convertible
preferred shares.
For dilutive net income per share purposes, the Series A and B preferred
shares are considered dilutive whenever annualized basic net income per share
exceeds each Series' annualized dividend divided by the conversion rate
applicable for that period. The Series A preferred shares were dilutive
throughout 2001. The Series B preferred shares were dilutive after the new
conversion rate went into effect, even though few actual Series B conversions
occurred because it was uneconomical to convert at the market prices of both the
common shares and Series B preferred shares in effect during the year.
NOTE 3 -- CALCULATION OF NET INCOME (LOSS)
PER COMMON SHARE
The components of the computation of basic and diluted net income (loss)
per share were as follows (in thousands, except per share data):
<Table>
<Caption>
YEAR ENDED DECEMBER 31
------------------------------------------
2001 2000 1999
---------- ---------- ----------
NUMERATOR FOR BASIC NET INCOME (LOSS) PER COMMON SHARE:
Net income (loss) $ 106,276 $ (51,486) $ 57,909
Less preferred share dividends:
Series A (485) (598) (598)
Series B (19,961) (20,322) (21,391)
Series B repurchase amount less than (in excess of) book value* -- 1,286 (251)
Series C and D -- (4,626) (316)
---------- ---------- ----------
$ 85,830 $ (75,746) $ 35,353
========== ========== ==========
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING 13,351 11,487 14,587
========== ========== ==========
BASIC NET INCOME (LOSS) PER COMMON SHARE $ 6.43 $ (6.59) $ 2.42
========== ========== ==========
NUMERATOR FOR DILUTED NET INCOME (LOSS) PER COMMON SHARE:
Net income (loss) $ 106,276 $ (51,486) $ 57,909
Less cash dividends paid on antidilutive convertible
preferred shares:
Series A -- (598) (598)
Series B ** (9,981) (20,322) (21,391)
Series B repurchase amount less than (in excess of) book value* -- 1,286 (251)
Series C (converted into common shares May 4, 2001) -- (3,012) --
Series D (converted into common shares December 28, 2000) -- (1,614) --
---------- ---------- ----------
$ 96,295 $ (75,746) $ 35,669
========== ========== ==========
DENOMINATOR FOR DILUTED NET INCOME (LOSS) PER COMMON SHARE:
Weighted average common shares outstanding 13,351 11,487 14,587
Net effect of dilutive stock options 84 -- 5
Net effect of dilutive convertible preferred shares:
Series A 241 -- --
Series B ** 2,827 -- --
Series C and D 453 -- 170
---------- ---------- ----------
16,956 11,487 14,762
========== ========== ==========
DILUTED NET INCOME (LOSS) PER COMMON SHARE $ 5.68 $ (6.59) $ 2.42
========== ========== ==========
</Table>
* 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.
** Reflects the Series B preferred shares as antidilutive prior to the July
2, 2001 change in conversion rates.
NOTE 4 -- MORTGAGE SECURITIES AND OTHER INVESTMENTS
Mortgage securities and other investments and the related weighted average
interest rates were as follows (dollars in thousands):
<Table>
<Caption>
AVERAGE AVERAGE
PRINCIPAL PREMIUMS CARRYING COUPON EFFECTIVE
BALANCE (DISCOUNTS) BASIS AMOUNT RATE RATE
---------- ----------- ----------- ----------- ------- ---------
DECEMBER 31, 2001 * ** **
Agency Securities:
Fannie Mae/Freddie Mac:
Fixed-rate $ 5,706 $ 34 $ 5,740 $ 5,981 10.00% 9.29%
Medium-term 40,559 (149) 40,410 41,544 6.19 6.44
LIBOR/CMT ARMs 1,543,867 25,286 1,569,153 1,593,115 6.88 6.59
COFI ARMs 167,080 (4,839) 162,241 168,856 5.31 6.45
Ginnie Mae ARMs 1,368,551 14,460 1,383,011 1,398,908 6.37 6.40
---------- ----------- ----------- -----------
3,125,763 34,792 3,160,555 3,208,404 6.57 6.49
Non-agency securities 73,040 373 73,413 74,839 6.94 7.58
CMBS - adjustable-rate 172,071 (380) 171,691 171,976 3.69 6.46
---------- ----------- ----------- -----------
$3,370,874 $ 34,785 $ 3,405,659 $ 3,455,219 6.43 6.52
========== =========== =========== ===========
DECEMBER 31, 2000
Agency Securities:
Fannie Mae/Freddie Mac:
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
Ginnie Mae 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
========== =========== =========== ===========
</Table>
* Includes unrealized gains and losses for securities classified as
available-for-sale, if applicable (see NOTE 8).
** Average Coupon Rate is presented as of the indicated balance sheet date.
Average Effective Rate is presented for the year then ended, calculated
including the amortization of premiums and discounts, 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 have fixed rates of interest
for their entire 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 the 1-year Constant Maturity U.S.
Treasury Note Rate ("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 initial expected weighted average lives of 5 years
or less. Adjustable-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 an index such as LIBOR or 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, 2001 adjust monthly based on a specified margin over 30-day LIBOR.
Agency Securities are AAA-rated and are considered to have limited credit
risk. Non-agency securities consist of (i) private mortgage pass-through
securities backed primarily by single-family non-conforming residential mortgage
loans whereby the related credit risk of the underlying loans is borne by
AAA-rated private mortgage insurers and (ii) other AAA-rated private mortgage
securities (together, "Non-agency Securities"). Commercial mortgage
securitizations generally have senior, mezzanine and subordinate classes of
bonds with the lower bond classes providing credit enhancement to the more
senior classes. CMBS held by the Company at December 31, 2001 are mezzanine
classes and therefore carry credit risk associated with the underlying pools of
commercial mortgage loans that is mitigated by subordinate bonds held by other
investors. 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 another $700 million of primarily medium-term securities,
incurring charges of $70.9 million included in Gain (loss) on sale of mortgage
assets, and $19.1 million included in Impairment on mortgage assets. During
2001, $451 million of medium-term securities previously written down as impaired
were sold for a gain of $5.9 million. Remaining securities written down in 2000
were carried at an unrealized gain of $6.6 million at December 31, 2001.
NOTE 5 -- CMO COLLATERAL AND INVESTMENTS
CMO collateral consists of primarily fixed-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 primarily 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 retained
$478,000 of credit risk held in the form of subordinated bonds associated with
$238 million of Pledged CMO Collateral outstanding at December 31, 2001. The
weighted average effective interest rate for total Pledged CMO Collateral was
7.24% and 7.28% during 2001 and 2000, 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 $96 million of loans outstanding as of
December 31, 2001 from the related securitizations. The components of CMO
collateral and investments were as follows (in thousands):
<Table>
<Caption>
DECEMBER 31
-------------------------
2001 2000
---------- ----------
Pledged CMO Collateral:
Pledged mortgage securities $2,231,324 $3,088,579
Short-term investments 30 491
Accrued interest receivable 13,329 18,675
---------- ----------
2,244,683 3,107,745
Unamortized premium 14,860 16,322
---------- ----------
2,259,543 3,124,067
CMO investments 2,762 2,811
---------- ----------
$2,262,305 $3,126,878
========== ==========
</Table>
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 initial
maturities and may feature renewal options. The terms and conditions of these
arrangements are negotiated on a transaction-by-transaction basis. Repurchase
arrangements and related weighted average interest rates for the dates
indicated, classified by type of collateral and maturities, were as follows
(dollars in thousands):
<Table>
<Caption>
DECEMBER 31, 2001 DECEMBER 31, 2000
----------------------- ----------------------
BORROWINGS AVERAGE BORROWINGS AVERAGE
OUTSTANDING RATE OUTSTANDING RATE
----------- -------- ----------- -------
Agency Securities (less than 31 days) $ 2,999,860 1.88% $ 4,616,784 6.58%
Agency Securities (31 to 90 days) -- -- 218,104 6.55
Non-agency Securities (less than 31 days) 55,602 2.05 6,947 6.90
CMBS (less than 1 year) 151,606 2.23 49,145 7.25
CMBS (over 1 year) -- -- 13,652 7.25
----------- -----------
$ 3,207,068 1.90 $ 4,904,632 6.59
=========== ===========
</Table>
The weighted average effective interest rate on borrowings under repurchase
arrangements was 4.18% and 6.31% during 2001 and 2000, respectively. Interest
paid on borrowings totaled $180.7 million, $301.1 million and $221.4 million
during 2001, 2000 and 1999, 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):
<Table>
<Caption>
DECEMBER 31
-----------------------------
2001 2000
------------- -------------
CMOs $ 2,228,091 $ 3,087,167
Accrued interest payable 12,253 17,768
------------- -------------
Total obligation 2,240,344 3,104,935
Unamortized premium (discount) 4,671 (1,061)
------------- -------------
$ 2,245,015 $ 3,103,874
============= =============
Range of average interest rates 2.29% to 9.45% 4.95% to 9.45%
Range of stated maturities 2008 to 2030 2008 to 2030
Number of series 19 26
</Table>
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 7.27% and 7.35% during 2001 and 2000, respectively.
Interest paid on CMOs totaled $194.5 million, $226.6 million and $260.2 million
during 2001, 2000 and 1999, respectively.
NOTE 8 -- DISCLOSURES REGARDING FAIR VALUES
OF FINANCIAL INSTRUMENTS
The carrying amounts of cash and cash equivalents, receivables, payables
and borrowings under repurchase arrangements approximate fair value. The fair
value of Agency Securities, 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):
<Table>
<Caption>
DECEMBER 31, 2001 DECEMBER 31, 2000
------------------------- -------------------------
CARRYING FAIR CARRYING FAIR
AMOUNT VALUE AMOUNT VALUE
---------- ---------- ---------- ----------
ASSETS:
Cash and cash equivalents $ 123,520 $ 123,520 $ 21,761 $ 21,761
Receivables 49,283 49,283 61,587 61,587
Call right Derivatives 709 709 -- --
Mortgage securities and other investments 3,455,219 3,455,592 5,394,459 5,394,459
CMO collateral and investments 2,262,305 2,250,433 3,126,878 3,084,153
LIABILITIES:
Payables 38,614 38,614 31,112 31,112
Borrowings under repurchase arrangements 3,207,068 3,207,068 4,904,632 4,904,632
CMOs 2,245,015 2,241,772 3,103,874 3,074,271
</Table>
Fair value disclosures for available-for-sale debt securities were as
follows (in thousands):
<Table>
<Caption>
GROSS GROSS
COST UNREALIZED UNREALIZED FAIR
BASIS GAINS LOSSES VALUE
---------- ---------- ---------- ----------
AS OF DECEMBER 31, 2001
Agency Securities:
Fixed-rate $ 2,596 $ 241 $ -- $ 2,837
Medium-term 40,410 1,134 -- 41,544
ARMs 3,114,405 46,680 206 3,160,879
---------- ---------- ---------- ----------
3,157,411 48,055 206 3,205,260
Non-agency Securities 72,458 1,426 -- 73,884
CMBS - adjustable-rate 171,691 285 -- 171,976
CMO collateral and investments 44,644 1,491 38 46,097
---------- ---------- ---------- ----------
$3,446,204 $ 51,257 $ 244 $3,497,217
========== ========== ========== ==========
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
========== ========== ========== ==========
</Table>
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):
<Table>
<Caption>
GROSS GROSS
COST UNREALIZED UNREALIZED FAIR
BASIS GAINS LOSSES VALUE
---------- ---------- ---------- ----------
AS OF DECEMBER 31, 2001
Released CMO collateral:
Agency Securities $ 3,144 $ 285 $ -- $ 3,429
Non-agency Securities 955 88 -- 1,043
Pledged CMO Collateral 2,216,208 1,455 10,084 2,207,579
---------- ---------- ---------- ----------
$2,220,307 $ 1,828 $ 10,084 $2,212,051
========== ========== ========== ==========
AS OF DECEMBER 31, 2000
Pledged CMO Collateral $3,052,205 $ 1,204 $ 14,326 $3,039,083
========== ========== ========== ==========
</Table>
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):
<Table>
<Caption>
YEAR ENDED DECEMBER 31
-----------------------------------------------
2001 2000 1999
------------ ------------ ------------
Sale of securities held available-for-sale:
Amortized cost $ 474,441 $ 1,389,947 $ 7,573
Gain 6,210 -- 1,761
Loss -- (70,989) --
Sale of released CMO collateral held-to-maturity:
Amortized cost 94,157 84,547 --
Gain 1,746 816 --
</Table>
NOTE 9 -- INCOME TAXES
Capstead and its qualified REIT subsidiaries ("Capstead REIT") file a
separate federal income tax return that does not include the operations of the
Company's non-REIT subsidiaries. Provided all taxable income of Capstead REIT is
distributed to stockholders within time limits prescribed by the Code, no income
taxes are due on this income. Taxable income, if any, of the non-REIT
subsidiaries is fully taxable. In connection with utilizing operating loss
carryforwards at the non-REIT subsidiaries, alternative minimum taxes of $2,000
were paid during 2000. No income taxes were paid during 2001 or 1999.
Effective tax rates differed substantially from statutory federal income
tax rates because of the effect of the following items (in thousands):
<Table>
<Caption>
YEAR ENDED DECEMBER 31
-----------------------------------------------
2001 2000 1999
------------ ------------ ------------
Income taxes computed at the federal statutory rate $ 37,197 $ (18,020) $ 20,268
Capital gain generated by Capstead REIT (970) (262) (3,298)
Capital loss generated by Capstead REIT 609 25,041 --
Benefit of REIT status (39,163) (6,820) (16,973)
------------ ------------ ------------
Income taxes computed on income of non-REIT subsidiaries (2,327) (61) (3)
Change in unrecognized deferred income tax asset 2,570 (235) 839
Other (243) 298 (836)
------------ ------------ ------------
$ -- $ 2 $ --
============ ============ ============
</Table>
At December 31, 2001 Capstead REIT had capital loss carryforwards for tax
purposes of $330 million, of which $260 million expires after 2003, and $70
million expires after 2005. At December 31, 2001 the non-REIT subsidiaries had
net operating loss carryforwards for tax purposes of $6.6 million ($3.1 million
expires after 2012 and $3.5 million expires after 2019) and capital loss
carryforwards of $4.6 million, which expire after 2006. In addition, the
non-REIT subsidiaries have sufficient alternative minimum tax credit
carryforwards to offset the payment of federal income taxes on $5.0 million of
future alternative minimum taxable income, if any, earned by these subsidiaries.
Significant components of the non-REIT subsidiaries deferred income tax assets
and liabilities were as follows (in thousands):
<Table>
<Caption>
DECEMBER 31
--------------------------
2001 2000
---------- ----------
Deferred income tax assets:
Alternative minimum tax credit $ 1,751 $ 1,753
Capital loss carryforwards 1,606 --
Net operating loss carryforwards 994 1,149
Other 1,259 668
---------- ----------
5,610 3,570
Deferred income tax liabilities (14) (544)
---------- ----------
Net deferred tax assets $ 5,596 $ 3,026
========== ==========
Valuation allowance $ 5,596 $ 3,026
========== ==========
</Table>
NOTE 10 -- STOCKHOLDERS' EQUITY AND PREFERRED STOCK
SUBJECT TO REPURCHASE
As of December 31, 2001, the Company had two series of convertible
preferred stock outstanding, ranking on parity with each other and ahead of the
common shares in the event of liquidation. These shares are currently redeemable
at the Company's option. Dividends are payable quarterly for the Series A shares
and monthly for the Series B shares.
Capstead's preferred shares are each entitled to cumulative fixed dividends
with conversion rates and redemption and liquidation preferences as indicated
below:
<Table>
<Caption>
PER SHARE
------------------------------------------------
PREFERRED ANNUALIZED CONVERSION REDEMPTION LIQUIDATION
SERIES DIVIDEND RATE PRICE PREFERENCE
--------- ---------- ---------- ---------- -----------
*
A $1.60 0.9657 $16.40 $16.40
B 1.26 0.3559 12.50 11.38
</Table>
* Reflects number of common shares to be received for each
preferred share converted effective July 2, 2001 (see NOTE 2).
During 2001, 100,600 Series A shares and 2,473 Series B shares
were converted into 80,763 and 550 common shares,
respectively.
On December 9, 1999 Capstead issued 5,378,000 of Series C preferred shares
and 5,378,000 of Series D preferred shares to Fortress that were converted on
May 4, 2001 and on December 28, 2000, respectively, into an aggregate of
2,689,000 common shares. In addition, during 2000 Fortress acquired an aggregate
of 1,960,359 Capstead common shares through open market purchases and a May 2000
tender offer, bringing its holdings to 4,649,359 common shares. In November
2001, Fortress sold one million of these shares in an underwritten offering. As
of December 31, 2001, Fortress was Capstead's largest stockholder, owning
3,649,359 common shares, or 26% of the Company's outstanding common shares (see
NOTE 13).
In February 1999, the Board of Directors authorized the repurchase of up to
1.5 million common shares and up to 2 million Series B shares. Pursuant to this
repurchase program, the Company repurchased 188,475 and 901,875 common shares
during 2000 and 1999, respectively, at an average price of $15.53 and $19.67 per
share. Also pursuant to this program, the Company repurchased 826,900 and
622,000 Series B shares during 2000 and 1999, respectively, at an average price
of $9.61 and $11.57 per share. No shares were repurchased during 2001 pursuant
to this repurchase program. On January 25, 2000 the Company repurchased
2,784,250 common shares at a price of $18.54 per share pursuant to a tender
offer. On March 22, 2001 the Company repurchased 275,845 common shares at a
price of $26.50 per share pursuant to a tender offer. All of the above per share
prices include transaction costs. All repurchased shares have been cancelled.
Option exercises by directors resulted in net additions to capital of
$419,000, $37,000 and $-0- during 2001, 2000 and 1999, respectively. Option
exercises by officers resulted in net additions to capital of $747,000 during
2001. No options were exercised by officers in 2000 or 1999.
Capstead's Charter provides that if the Board determines in good faith that
the direct or indirect ownership of the common shares 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.
The following provides information regarding comprehensive income (loss)
(in thousands):
<Table>
<Caption>
YEAR ENDED DECEMBER 31
------------------------------------------------
2001 2000 1999
------------ ------------ ------------
Net income (loss) $ 106,276 $ (51,486) $ 57,909
------------ ------------ ------------
Other comprehensive income (loss):
Unrealized gain on cash flow hedges:
Initial gain upon adoption of SFAS 133 1,365 -- --
Change in unrealized gain during period (354) -- --
Reclassification adjustment for amounts
included in net income (70) -- --
Unrealized gain (loss) on debt securities:
Change in unrealized gain (loss) during period 37,778 22,656 (93,831)
Reclassification adjustment for amounts
included in net income (loss) (6,210) 90,077 1,761
------------ ------------ ------------
Other comprehensive income (loss) 32,509 112,733 (92,070)
------------ ------------ ------------
Comprehensive income (loss) $ 138,785 $ 61,247 $ (34,161)
============ ============ ============
</Table>
NOTE 11 -- EMPLOYEE AND DIRECTOR BENEFIT PLANS
The Company sponsors stock plans for directors and employees to provide for
the issuance of nonvested stock, stock options and other incentive-based stock
awards (collectively, the "Plans"). The Plans provide for the issuance of up to
an aggregate of 1,878,125 common shares.
Nonvested stock grants for 53,577 common shares were issued to employees
other than the chairman on April 20, 2000 (grant date fair value $14.25 per
share). These grants are subject to certain restrictions, including continuous
employment, which generally lapse over five 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.
Stock options granted have terms and vesting requirements at the grant date
of up to 10 years. Certain outstanding stock options previously granted to
directors provide for the annual granting of dividend equivalent rights ("DERs")
that permit the optionholder to obtain additional common shares based upon
formulas set forth in the Plans. The following tables provide information
regarding option grants outstanding as of December 31, 2001 and stock option
activity for the periods indicated:
<Table>
<Caption>
RANGE OF
-------------------------------
OPTIONS OPTIONS EXERCISE REMAINING
ORIGINAL GRANT DATE OUTSTANDING EXERCISABLE PRICES LIFE (YEARS)
---------------------------- ----------- ----------- ---------------- ------------
* *
After December 1998 117,938 28,589 $ 8.26 to $20.99 3 to 10
January 1998 and prior 213,369 213,369 $30.28 to $53.37 1 to 6
-------- -----------
331,307 241,958
======== ===========
</Table>
* Weighted average exercise prices and weighted average lives of these
significant option grants were $10.20 and 8 years, and $43.21 and 5
years, respectively.
<Table>
<Caption>
NUMBER OF WEIGHTED AVERAGE
SHARES EXERCISE PRICE
--------- ----------------
As of January 1, 1999 (987,186 exercisable) 987,186 $71.48
Canceled (615,613) 71.24
Granted (average fair value: $2.78 per share) 2,813 16.50
---------
As of December 31, 1999 (374,386 exercisable) 374,386 71.42
Canceled (248,518) 70.80
Exercised (2,295) 16.30
Granted (average fair value: $1.92 per share) 116,671 14.30
DERs granted (average fair value: $16.76 per share) 1,307 --
---------
As of December 31, 2000 (162,486 exercisable) 241,551 44.62
Canceled * (189,941) 52.94
Exercised (76,337) 15.33
Granted in connection with recapitalization * 321,971 31.23
Ordinary grants (average fair value: $1.87 per share) 34,063 21.05
---------
As of December 31, 2001 (241,958 exercisable) 331,307 31.46
=========
</Table>
* In connection with the payment of the special common dividend on June
29, 2001, all existing options were canceled and replaced with new
option grants. Each canceled grant was replaced with a new grant for an
increased number of shares at a reduced exercise price that retained
the same vesting and expiration characteristics as the canceled grants
such that the optionholder's economic position remained unchanged
subsequent to the recapitalization. The new grants are accounted for as
non-compensatory because they were issued in connection with this
recapitalization of the Company.
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 totaled $136,000 and $108,000 in 2001 and 2000, 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 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 15%, volatility factors of 30% to 53%, expected life assumptions of 1
to 5 years and risk-free rates of between 4.4% 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 $47,000, $161,000 and $113,000 in 2001, 2000 and
1999, respectively.
NOTE 12 -- 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. In March 1999, these actions were consolidated
and in July 2000, the court appointed a lead plaintiff group. An amended
complaint was filed in October 2000. The amended complaint claims that as a
result of alleged improper actions, the market prices of the Company's equity
securities were artificially inflated during the period between April 17, 1997
and June 26, 1998. The amended complaint seeks monetary damages in an
undetermined amount. In February 2001 the Company responded to this amended
complaint with a motion to dismiss all allegations against the Company and the
named officers. In April 2001 the plaintiffs responded to the Company's motion
to dismiss and the Company filed its reply to the plaintiffs' response in May
2001. 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.
NOTE 13 -- TRANSACTIONS WITH FORTRESS
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 Wesley R. Edens as Capstead's Chairman of the Board and Chief
Executive Officer 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 members of the Board of
Directors that are independent of Fortress. Mr. Edens is also the chairman of
the board of Fortress.
Under the terms of this contract, Fortress is entitled to receive a base
annual fee of $375,000 and a cash management incentive fee (see NOTE 2). In
addition, 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 $375,000 and $260,417 of base fees paid to Fortress for services
rendered during 2001 and from April 20, 2000 through December 31, 2000,
respectively. Included in Management and affiliate incentive fee is $8,133,150
and $130,208 of cash management incentive fees payable to Fortress for these
periods, respectively. No long-term noncash compensation has been awarded.
Under a separate arrangement, which terminated in early 2001, the Company
provided accounting and cash management services to Fortress for one of its
affiliates. Included in Other revenue is $33,000 and $160,000 Capstead received
pursuant to this arrangement for services rendered in 2001 and 2000,
respectively.
NOTE 14 -- NET INTEREST INCOME ANALYSIS (UNAUDITED)
The following summarizes interest income and interest expense and weighted
average interest rates (dollars in thousands):
<Table>
<Caption>
2001 2000 1999
------------------ ------------------ ------------------
AVERAGE AVERAGE AVERAGE
EFFECTIVE EFFECTIVE EFFECTIVE
AMOUNT RATE AMOUNT RATE AMOUNT RATE
-------- --------- -------- --------- -------- ---------
Interest income:
Mortgage securities and other
investments $274,480 6.52% $349,533 6.68% $293,841 5.87%
CMO collateral and investments 198,216 7.24 237,052 7.28 269,318 7.16
-------- -------- --------
Total interest income 472,696 586,585 563,159
-------- -------- --------
Interest expense:
Borrowings under repurchase
arrangements 164,422 4.18 303,126 6.31 232,852 5.16
CMOs 197,905 7.27 237,479 7.35 270,081 7.24
-------- -------- --------
Total interest expense 362,327 540,605 502,933
-------- -------- --------
$110,369 $ 45,980 $ 60,226
======== ======== ========
</Table>
Changes in interest income and interest expense due to changes in interest
rates versus changes in volume were as follows (in thousands):
<Table>
<Caption>
RATE VOLUME TOTAL
---------- ---------- ----------
* * *
2001/2000
Interest income:
Mortgage securities and other investments $ (7,746) $ (67,307) $ (75,053)
CMO collateral and investments (1,167) (37,669) (38,836)
---------- ---------- ----------
Total interest income (8,913) (104,976) (113,889)
---------- ---------- ----------
Interest expense:
Borrowings under repurchase arrangements (89,930) (48,774) (138,704)
CMOs (2,528) (37,046) (39,574)
---------- ---------- ----------
Total interest expense (92,458) (85,820) (178,278)
---------- ---------- ----------
$ 83,545 $ (19,156) $ 64,389
========== ========== ==========
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)
========== ========== ==========
</Table>
* 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 15 -- QUARTERLY RESULTS (UNAUDITED)
Summarized quarterly results of operations were as follows (in thousands,
except percentages and per share amounts).
<Table>
<Caption>
1ST QUARTER 2ND QUARTER 3RD QUARTER 4TH QUARTER
----------- ----------- ----------- -----------
YEAR ENDED DECEMBER 31, 2001
Interest income $ 143,327 $ 126,465 $ 108,193 $ 94,711
Interest and related expenses 121,105 98,287 81,414 62,511
----------- ----------- ----------- -----------
Net margin on mortgage assets and other investments 22,222 28,178 26,779 32,200
Other revenue (expense) 2,427 (409) (1,703) (3,418)
----------- ----------- ----------- -----------
$ 24,649 $ 27,769 $ 25,076 $ 28,782
=========== =========== =========== ===========
Net income per common share:
Basic $ 1.49 $ 1.77 $ 1.45 $ 1.71
Diluted 1.39 1.63 1.27 1.45
</Table>
<Table>
<Caption>
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 revenue (expense) (945) (94,278) 104 (802)
----------- ----------- ----------- -----------
$ 11,670 $ (84,252) $ 9,767 $ 11,329
=========== =========== =========== ===========
Net income per common share:
Basic $ 0.44 $ (7.97) $ 0.30 $ 0.48
Diluted 0.44 (7.97) 0.30 0.43
</Table>
NOTE 16 -- MARKET AND DIVIDEND INFORMATION (UNAUDITED)
The New York Stock Exchange trading symbol for Capstead's common shares is
CMO. There were 2,825 common stockholders of record at December 31, 2001. In
addition, depository companies held common shares for 20,706 beneficial owners.
The high and low sales prices and dividends declared on the common shares were
as follows:
<Table>
<Caption>
YEAR ENDED DECEMBER 31, 2001 YEAR ENDED DECEMBER 31, 2000
---------------------------- ----------------------------
SALES PRICES SALES PRICES
----------------- DIVIDENDS ----------------- DIVIDENDS
HIGH LOW DECLARED HIGH LOW DECLARED
-------- ------- --------- -------- ------- ---------
First quarter $26.90 $ 21.50 $0.98 $18.25 $ 14.50 $0.44
Second quarter 36.40 26.20 1.56 17.75 12.00 0.32
Third quarter 28.49 19.01 1.50 19.38 15.75 0.24
Fourth quarter 29.50 23.50 1.50 24.00 17.88 0.42
</Table>
SELECTED FINANCIAL DATA
(In thousands, except per share amounts)
<Table>
<Caption>
YEAR ENDED DECEMBER 31
-------------------------------------------------------------------------------
2001 2000 1999 1998 1997
----------- ----------- ----------- ----------- -----------
SELECTED CONSOLIDATED STATEMENT
OF OPERATIONS DATA:
Interest income $ 472,696 $ 586,585 $ 563,159 $ 667,198 $ 694,259
Interest and related expense 363,317 542,150 504,947 659,575 616,287
----------- ----------- ----------- ----------- -----------
Net margin on mortgage assets and other
investments 109,379 44,435 58,212 7,623 77,972
Net margin on mortgage banking
operations (a) -- -- -- 11,821 59,422
Other revenue (expense) (b) (3,103) (95,921) (303) (254,208) 22,532
----------- ----------- ----------- ----------- -----------
Net income (loss) $ 106,276 $ (51,486) $ 57,909 $ (234,764) $ 159,926
=========== =========== =========== =========== ===========
Net income (loss) per common share: (c)
Basic $ 6.43 $ (6.59) $ 2.42 $ (16.87) 10.49
Diluted 5.68 (6.59) 2.42 (16.87) 9.40
Cash dividends paid per share: (c)
Common - regular 5.54 1.42 2.40 4.00 9.60
Common - special (d) 14.60 -- -- -- --
$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 (e) -- 0.56 0.03 -- --
$0.40 Series D Preferred (e) -- 0.30 0.02 -- --
Average number of common shares
outstanding: (c)
Basic 13,351 11,487 14,587 15,237 12,814
Diluted 16,956 11,487 14,762 15,237 17,006
SELECTED CONSOLIDATED BALANCE SHEET DATA:
Mortgage securities and other investments $ 3,455,219 $ 5,394,459 $ 5,408,714 $ 2,369,602 $ 6,114,130
CMO collateral and investments 2,262,305 3,126,878 3,318,886 4,571,274 5,195,436
Mortgage servicing rights (a) -- -- -- -- 669,062
Total assets 5,895,425 8,610,497 8,807,039 7,100,287 12,357,515
Borrowings under repurchase arrangements 3,207,068 4,904,632 4,872,392 1,839,868 7,099,706
Collateralized mortgage obligations 2,245,015 3,103,874 3,289,584 4,521,324 4,309,455
Preferred stock subject to repurchase (e) -- 25,210 50,584 -- --
Stockholders' equity 404,728 545,669 563,806 680,201 888,608
</Table>
NOTE: See "Management's Discussion and Analysis of Financial Condition and
Results of Operations" and "Notes to Consolidated Financial Statements"
for discussion of changes to the Company's operations that are expected
to impact future operating results.
(a) The mortgage banking operations, including related mortgage servicing
rights, were sold in December 1998.
(b) Results in 2000 include losses on the sale of mortgage assets incurred
with the modification of the Company's investment strategy to focus on
adjustable-rate mortgage assets. Results in 1998 include losses from the
sale of mortgage assets, principally interest-only mortgage securities.
(c) Amounts have been adjusted for two 1-for-2 reverse common stock splits
effective July 2, 2001 and May 8, 2000, respectively.
(d) On June 29, 2001 the Company paid a $14.60 special common dividend
aggregating $201 million that was recorded as a reduction of
Paid-in-capital.
(e) The Series C and D preferred shares were converted into common shares on
May 4, 2001 and December 28, 2000, respectively.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
FINANCIAL CONDITION
OVERVIEW
Capstead Mortgage Corporation ("Capstead" or the "Company") operates as a
real estate investment trust ("REIT") earning income from investing in real
estate-related assets on a leveraged basis and from other investment strategies.
These investments currently include, but are 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"). The Company has also made limited investments in
credit-sensitive, commercial mortgage assets and has made changes in its capital
structure designed to enhance its capability to generate attractive returns to
common stockholders. As existing investments prepay or mature, Capstead has the
opportunity to reinvest a portion of its equity capital into investments that
can produce attractive returns over the long term, with less sensitivity to
changes in interest rates than Agency Securities. To this end, the Company
continues to actively evaluate suitable real estate-related investments, which
may include more credit-sensitive assets that can earn attractive returns due
largely to a higher risk of default and reduced liquidity compared to Agency
Securities. There can be no assurance that suitable investments at attractive
pricing will be available on a timely basis to replace portfolio runoff as it
occurs (see "Effects of Interest Rate Changes" and "Risks Associated with
Credit-Sensitive Investments").
CHANGES IN CAPITAL STRUCTURE
Between December 1998 and March 2001, Capstead repurchased nearly 29% of
its common shares at prices below prevailing book value. Net of conversions of
preferred shares, these repurchases reduced common equity by over $32 million.
On June 29, 2001 Capstead further reduced common equity by returning over $201
million to its common stockholders in the form of a special dividend
distribution of $14.60 per common share. This special dividend distribution
reduced common book value per share by nearly 50% and, together with the earlier
share repurchases, created a capital structure capable of generating attractive
returns to common stockholders by significantly reducing common equity capital
relative to total equity capital. Of course, while the new capital structure can
produce higher percentage returns on common equity under favorable conditions
than before the capital reductions, declines in earnings or book value can also
have a more pronounced impact on these returns.
In conjunction with the special dividend, on June 15, 2001 stockholders
approved a 1-for-2 reverse common stock split. The common shares began trading
on a post-reverse split basis on July 2, 2001, which coincided with the first
day the common shares traded ex-special dividend. All references to common
shares and per common share amounts have been adjusted to reflect the reverse
split.
The Company's book value per common share was $14.59 at December 31, 2001
(calculated assuming the redemption of the Series A and B preferred shares).
Adding back the $14.60 special dividend, this represents an improvement in book
value of $2.97 per common share during 2001, from $26.22 at December 31, 2000.
This increase is largely attributable to the positive impact on the market value
of the mortgage investment portfolio from lower prevailing interest rates,
offset by portfolio runoff. Book value also benefited during 2001 from $8.0
million of undistributed gain on mortgage asset sales and, to a lesser extent, a
March tender for 275,845 common shares at a price of $26.50 per share (including
transaction costs). The market value of Capstead's mortgage assets will continue
to fluctuate with changes in interest rates and market liquidity, and such
changes will generally be reflected in book value per common share. Book value
will also be affected by other factors, including the level of dividend
distributions and the size and composition of the Company's investment
portfolios.
On May 4, 2001 Fortress Investment Group LLC ("Fortress"), Capstead's
largest stockholder, converted the Series C preferred shares it acquired through
its affiliate in December 1999 into 1,344,500 common shares. In November 2001
Fortress reduced its control of Capstead's voting shares from 34% to 26% through
the sale of one million Capstead common shares in an underwritten offering.
Wesley R. Edens, Capstead's Chairman of the Board and Chief Executive Officer,
is also chairman of the board of Fortress.
MORTGAGE SECURITIES AND OTHER INVESTMENTS
As of December 31, 2001, mortgage securities and other investments
consisted 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 are considered to have limited
credit risk. Non-agency securities consist of (i) private mortgage pass-through
securities whereby the related credit risk of the underlying loans is borne by
AAA-rated private mortgage insurers and (ii) other AAA-rated private mortgage
securities (together, "Non-agency Securities"). Commercial mortgage-backed
securitizations ("CMBS") generally have senior, mezzanine and subordinate
classes of bonds with the lower classes providing credit enhancement to the more
senior classes. CMBS held by the Company at December 31, 2001 are mezzanine
classes and therefore carry credit risk associated with the underlying pools of
commercial mortgage loans that is mitigated by subordinate bonds held by other
investors (see "Risks Associated With Credit-Sensitive Investments"). Mortgage
securities are financed under repurchase arrangements with investment banking
firms pursuant to which the portfolios are pledged as collateral. Should the
Company acquire other investments that are not mortgage-backed securities,
financing arrangements with other parties, such as commercial banks, may be
employed (see "Liquidity and Capital Resources").
The Company's mortgage investment portfolio declined during 2001 to less
than $3.5 billion from $5.4 billion at December 31, 2000 as a result of
portfolio runoff and the first quarter sale of $451 million of medium-term
securities. Additions to the portfolio during 2001 have been limited to $102
million of ARM securities and $101 million of
adjustable-rate CMBS. To the extent proceeds of runoff or asset sales are not
reinvested or cannot be reinvested at a rate of return at least equal to the
rate previously earned on that capital, earnings may decline. The Company
continues to evaluate suitable real estate-related investments, which may
include credit-sensitive assets that can earn attractive returns due largely to
a higher risk of default and reduced liquidity compared to Agency Securities.
Capstead believes that such investments, when combined with the prudent use of
leverage, can provide attractive returns over the long term with less
sensitivity to changes in interest rates. The future size and composition of
Capstead's investment portfolios will depend on market conditions, including
levels of mortgage prepayments and the availability of suitable investments on a
timely basis at attractive pricing (see "Effects of Interest Rate Changes").
The following yield and cost analysis illustrates fourth quarter 2001
results by investment classification and anticipated first quarter 2002
financing spreads (the difference between yields earned on mortgage investments
and rates paid on related borrowings) as first projected by the Company on
January 30, 2002 (the date the Company released its fourth quarter 2001 results
and based on interest rates in effect at that date) (dollars in thousands):
<Table>
<Caption>
4TH QUARTER 2001 AVERAGE AS OF DECEMBER 31, 2001
------------------------------- ----------------------- PROJECTED LIFETIME
ACTUAL ACTUAL PREMIUMS 1ST QUARTER PREPAYMENT
BASIS YIELD/COST RUNOFF (DISCOUNTS) BASIS YIELD/COST ASSUMPTIONS
---------- ---------- ------ ----------- --------- ----------- -----------
(a) (a) (a) (a) (b) (b)
Agency Securities:
FNMA/FHLMC:
Fixed-rate $ 10,446 8.85% 22% $ 34 $ 5,740 9.54% 25%
Medium-term 64,900 6.00 33 (149) 40,410 6.19 30
ARMs:
LIBOR/CMT 1,640,018 5.96 33 25,286 1,569,153 5.52 40
COFI 168,951 5.71 23 (4,839) 162,241 5.76 18
GNMA ARMs 1,478,502 5.77 38 14,460 1,383,011 5.58 26
---------- ------- -----------
3,362,817 5.87 35 34,792 3,160,555 5.57 33
Non-agency Securities 78,463 6.74 37 373 73,413 6.27 35
CMBS - adjustable-rate 91,051 4.67 1 (380) 171,691 3.91 --
---------- ------- -----------
3,532,331 5.86 34 $34,785 3,405,659 5.50 31
=======
Borrowings 3,315,265 2.31 3,207,068 1.84
---------- -----------
Capital employed/
financing spread $ 217,066 3.55 $ 198,591 3.66
========== ===========
Return on assets (c) 3.64 3.83
</Table>
(a) Basis represents the Company's investment before unrealized gains and
losses. Actual asset yields, runoff rates, borrowing rates and resulting
financing spread are presented on an annualized basis.
(b) Projected annualized yields reflect ARM coupon resets and lifetime
prepayment assumptions as adjusted for expected annualized prepayments
over the next three months, as of January 30, 2002 (the date the Company
released its fourth quarter 2001 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) The Company uses its liquidity to pay down borrowings. Return on assets
is calculated on an annualized basis assuming the use of this liquidity
to reduce borrowing costs (see "Utilization of Capital and Liquidity").
Yields on ARM securities peaked during the first quarter of 2001 and then
began declining, reflecting the trend of declining interest rates that has been
evident since the Federal Reserve began lowering short-term interest rates in
January 2001. Yields on ARM securities fluctuate as coupon interest rates on the
underlying mortgage loans reset to reflect current interest rates and are
expected to continue to decline in 2002. For example, if interest rates
stabilize at rates in effect January 30, 2002, average quarterly yields on the
Company's current holdings of mortgage investments could decline a total of 134
basis points by the fourth quarter of 2002 from yields achieved the fourth
quarter of 2001. Actual yields will depend on fluctuations in, and market
expectations for fluctuations in, interest rates and levels of mortgage
prepayments (see "Effects of Interest Rate Changes").
Mortgage prepayment rates were relatively high during 2001 as many
homeowners took advantage of the lower interest rate environment to refinance
their mortgage loans. A substantial portion of the mortgage loans underlying the
Company's ARM securities have interest rates that have already reset to levels
at or below most current mortgage rates, reducing or eliminating the advantage
for these homeowners to refinance. Prepayments began to moderate the second half
of 2001 and may slow further in 2002 as the remaining loans reset to lower
levels. Annualized prepayment rates on Ginnie Mae ARM securities averaged 38.1%
during the fourth quarter of 2001, compared to a 40.3% annualized rate during
the third quarter of 2001 and the 18.4% level experienced during the fourth
quarter of 2000. Annualized prepayment rates on Fannie Mae and Freddie Mac ARM
securities averaged 32.8% during the fourth quarter of 2001 compared to 38.6%
during the prior quarter and 23.5% for the same period of 2000. While lower
prepayment levels improve mortgage investment yields by allowing related
purchase premiums to be recognized in operating results over a longer period,
higher prepayment levels shorten the period over which premiums are amortized
thus reducing investment yields. More importantly, high prepayment levels can
lead to lower portfolio balances as discussed above.
Actions taken by the Federal Reserve during 2001 to aggressively reduce
short-term interest rates resulted in significantly lower interest rates on the
Company's borrowings. The Federal Reserve reduced the Federal Funds Rate by a
total of 475 basis points during 2001, which contributed to a 426 basis point
decline in the Company's average borrowing rates from the fourth quarter of 2000
to 2.31% during the fourth quarter 2001. The Company's average borrowing rates
are expected to decline another 47 basis points during the first quarter of 2002
as the full effect of fourth quarter 2001 interest rate reductions are realized.
Any further changes in borrowing rates will depend primarily 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 changes in
financial market liquidity.
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. 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. Most of the Company's securitizations have been afforded
financing accounting treatment with the related collateral recorded as pledged
CMO collateral and the outstanding bonds recorded as CMO liabilities (referred
to as "financed CMOs"). Other securitizations issued by the Company in 1993 and
prior were treated as sales transactions (referred to as "sold CMOs"). During
2001, the Company did not issue any CMOs. From time to time, the Company
exercises its right to redeem previously issued CMOs (referred to as "clean-up
calls") and either sell or hold the released collateral for investment. During
2001, the Company exercised clean-up calls related to seven financed and three
sold CMOs acquiring $122 million of fixed-rate and $15 million of
adjustable-rate securities released from the related indentures. The Company
sold $117 million of the fixed-rate securities for a gain of $2.1 million.
Credit risk associated with CMO collateral is borne by AAA-rated private
mortgage insurers or by subordinated bonds usually sold to investors. As of
December 31, 2001, the Company had $478,000 of credit risk held in the form of
subordinated bonds retained by the Company associated with $238 million of
outstanding pledged CMO collateral. In connection with two 1993 sold CMOs,
Capstead retained $2.8 million of reserve funds that are available to pay
special hazard costs (e.g. earthquake or mudslide-related losses) or certain
bankruptcy costs associated with $96 million of loans outstanding as of December
31, 2001. Other than clean-up call rights, the Company does not hold any other
interests in sold CMOs.
CMO collateral and investments, net of related bonds, was $17.3 million at
December 31, 2001, down from $23.0 million at year-end 2000. Included in this
net investment are $10.2 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 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").
UTILIZATION OF CAPITAL AND POTENTIAL LIQUIDITY
The Company's utilization of capital and potential liquidity as of December
31, 2001 were as follows (in thousands):
<Table>
<Caption>
CAPITAL POTENTIAL
ASSETS BORROWINGS EMPLOYED LIQUIDITY
---------- ---------- ---------- ----------
*
Mortgage Investments:
Agency Securities $3,208,404 $2,999,860 $ 208,544 $ 114,847
Non-agency Securities 74,839 55,602 19,237 18,837
CMBS 171,976 151,606 20,370 1,990
---------- ---------- ---------- ----------
3,455,219 3,207,068 248,151 135,674
CMO collateral and investments 2,262,305 2,245,015 17,290 --
---------- ---------- ---------- ----------
$5,717,524 $5,452,083 265,441 135,674
========== ==========
Other assets, net of other liabilities 139,287 123,520**
---------- ----------
$ 404,728 $ 259,194
========== ==========
</Table>
* Based on maximum borrowings available under existing uncommitted
repurchase arrangements considering the fair value of related
collateral as of December 31, 2001 (see "Liquidity and Capital
Resources").
** Represents cash and cash equivalents.
The Company generally finances its mortgage investments 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
assets pledged under borrowing arrangements, principal prepayments and general
conditions in the investment banking, mortgage finance and real estate
industries. Future levels of financial leverage will be dependent upon many
factors, including the size and composition of the Company's investment
portfolios (see "Liquidity and Capital Resources" and "Effects of Interest Rate
Changes").
TAX CONSIDERATIONS OF COMMON DIVIDENDS, INCLUDING THE SPECIAL COMMON DIVIDEND
Each common dividend distribution applicable to the 2001 tax year
(including the special common dividend) consists of 28.9% ordinary taxable
income and 71.1% return of capital. This has been determined based on the ratio
of Capstead's taxable income for the year, less preferred dividend
distributions, to total common share distributions made for the year, applied to
each common dividend distribution, including the $14.60 special common dividend
paid in June, and the $1.50 fourth quarter regular dividend paid January 18,
2002. Common stockholders receiving all four regular quarterly dividends for
2001, as well as the special common dividend, received taxable income per common
share of $5.82 and return of capital per common share of $14.32. Common
stockholders should reduce the tax cost basis of their shares by the amount of
return of capital distributions received in 2001 and in prior years, if
applicable. Return of capital distributions received in excess of tax cost basis
should be reported as capital gain. Due to the complex nature of the applicable
tax rules, it is recommended that stockholders consult their tax advisors to
ensure proper tax treatment of common dividends received. The following table
provides the tax characteristics of Capstead's common dividend distributions for
the last five years:
<Table>
<Caption>
COMMON RETURN
DIVIDEND CAPITAL ORDINARY OF
TAX YEAR DISTRIBUTIONS GAIN INCOME CAPITAL
---------- ------------- ------- -------- -------
* * *
2001 $20.14 --% 28.9% 71.1%
2000 1.42 -- 70.4 29.6
1999 2.40 -- 100.0 --
1998 4.00 -- 92.0 8.0
1997 9.60 8.8 83.7 7.5
</Table>
* The indicated characterization percentage is applicable to
each quarterly or special common dividend received with
respect to a given tax year.
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):
<Table>
<Caption>
YEAR ENDED DECEMBER 31
------------------------------------------
2001 2000 1999
---------- ---------- ----------
Agency Securities $ 102,181 $ 36,626 $ 52,514
Non-agency Securities 5,458 6,900 8,043
CMBS 2,106 2,350 37
CMO collateral and investments (366) (1,441) (2,382)
---------- ---------- ----------
Net margin on mortgage assets 109,379 44,435 58,212
Other revenue (expense):
Gain (loss) on sale of mortgage assets 7,956 (70,173) 1,738
Impairment on mortgage assets -- (19,088) --
Severance charges -- (3,607) --
CMO administration and other 3,705 3,484 4,083
Management and affiliate incentive fee (9,422) (389) (295)
Other operating expense (5,342) (6,148) (5,829)
---------- ---------- ----------
Net income (loss) $ 106,276 $ (51,486) $ 57,909
========== ========== ==========
Net income (loss) per share:
Basic $ 6.43 $ (6.59) $ 2.42
Diluted 5.68 (6.59) 2.42
Operating * 5.55 1.46 2.30
</Table>
* Operating income per common share is calculated excluding gain
(loss) on sale of mortgage assets, impairment and severance
charges incurred in June 2000 and the dilutive effects of the
Series B preferred shares. See NOTE 2 to the accompanying
financial statements for discussion regarding the impact on the
calculation of diluted net income per share of adjustments to
preferred share conversion rates resulting from the June 29, 2001
special common dividend payment.
2001 COMPARED TO 2000
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.
Net margins on mortgage assets and financing spreads benefited from actions
taken by the Federal Reserve during 2001 to aggressively lower short-term
interest rates, which resulted in lower interest rates on the Company's
borrowings. Yields on ARM securities steadily increased during 2000 and peaked
in early 2001 before beginning to reset lower. Yields also benefited from the
sale or designation for sale of nearly all of the Company's fixed-rate and
medium-term securities during 2000 and the acquisition of over $2.3 billion of
ARM Agency Securities with the proceeds from these sales.
Financing spreads are expected to peak during the first quarter of 2002
before beginning to decline as yields on ARM securities continue to reset lower.
In addition, lower interest rates have spurred higher levels of mortgage
prepayments, reducing the overall size of the Company's mortgage investment
portfolios. See "Financial Condition - Mortgage Securities
and Other Investments" for further discussion of the effects on ARM yields and
borrowing rates of actions taken by the Federal Reserve to lower short-term
interest rates and the Company's goals regarding redeploying capital made
available by portfolio runoff.
Agency Securities contributed more to operating results during 2001 than in
2000 because of improvements in financing spreads as discussed above, despite a
smaller average outstanding portfolio in 2001. Yields for this portfolio
averaged 6.49% during the year, compared to 6.59% in 2000, while average
borrowing rates were 4.18% compared to 6.30% in 2000. Average yields peaked
during the first quarter of 2001 at 7.02% then declined to 5.87% by the fourth
quarter. The Agency Securities portfolio averaged $4.0 billion in size during
2001, compared to $5.0 billion in 2000.
Non-agency Securities contributed less to operating results during 2001
primarily as a result of a lower average outstanding portfolio. This portfolio
averaged $87 million in size during 2001 compared to $152 million in 2000.
Average yields for this portfolio (calculated including mortgage insurance
costs) were 7.58% during 2001, compared to 7.98% in 2000.
The CMBS portfolio contribution to operating results was relatively stable
year to year reflecting the benefit of pairing investments with borrowings that
have nearly matching interest rate adjustment features. These investments
yielded 6.46% during 2001 while borrowing rates averaged 4.47% producing a
financing spread of 1.99%. This compares with yields of 9.07% and borrowing
rates of 6.94% for a spread of 2.13% during 2000. An additional $101 million of
adjustable-rate CMBS was acquired in December 2001 bringing this portfolio to
$172 million at year-end.
CMO collateral and investments results continue to diminish as the related
CMO securitizations continue to runoff or are redeemed pursuant to clean-up
calls (see "Financial Condition - CMO Collateral and Investments"). 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.
Gain on sale of mortgage assets reflects sales of $117 million of
fixed-rate released CMO collateral and the sale of $451 million of medium-term
Agency Securities.
CMO administration revenue was lower in 2001 primarily because a declining
portfolio of CMOs for which Capstead provides administrative services. Other
revenue benefited from investing excess liquidity in short-term investments to
take advantage of positive spreads between interest rates on overnight
investments and short-term borrowing rates. The management and affiliate
incentive fee for 2001 reflects the Company's performance against predetermined
benchmarks established by members of the Board of Directors that are independent
of Fortress (see "NOTE 2" to the accompanying consolidated financial
statements). Other operating expenses were less in 2001 reflecting fewer
employees and lower administrative and systems-related costs.
2000 COMPARED TO 1999
Lower overall net margins on mortgage assets and financing spreads in 2000
compared to 1999 reflected higher borrowing rates primarily because of actions
taken by the Federal Reserve to increase short-term interest rates by a total of
175 basis points between June 1999 and May 2000. As a result, borrowing rates
averaged 115 basis points higher in 2000
compared to 1999 which were only partially offset by the benefits of improving
yields on ARM securities, the restructuring of the Company's mortgage investment
portfolio and relatively low mortgage asset prepayment levels.
Agency Securities contributed less to operating results during 2000 than in
1999 because of the higher borrowing costs, despite higher average yields.
Yields for this portfolio averaged 6.59% during 2000, compared to 5.81% in 1999,
while borrowing rates averaged 6.30% compared to 5.16% in 1999. Yields benefited
from the sale of relatively low-coupon fixed-rate and medium-term securities,
and higher yields on newly acquired ARM securities and securities written down
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 Agency Securities portfolio averaged $5.0 billion in size 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 portfolio averaged $152 million in size during 2000 compared to $120
million in 1999. Average borrowings during 2000 were $80 million, while in 1999
the portfolio was funded almost entirely with equity. Yields for this portfolio
(calculated including mortgage insurance costs) averaged 7.98% during 2000,
compared to 8.06% in 1999.
Capstead made its first acquisitions of CMBS in December 1999 and made only
modest additions to this portfolio in early 2000. These investments yielded
9.07% during the year while borrowing rates averaged 6.94% for a financing
spread of 2.13%.
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.
In April 2000, the Company realized losses of $70.9 million and recorded
impairment charges of $19.1 million for the sale, or designation for sale, of
most of its fixed-rate and medium-term securities. In addition, the Company
incurred severance charges of $3.6 million, related primarily to the resignation
of its former chief executive officer.
CMO administration results and other revenue were lower in 2000 primarily
because a declining portfolio of CMOs for which the Company provides
administrative services. Other operating expenses were fairly stable year to
year.
LIQUIDITY AND CAPITAL RESOURCES
Capstead'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 Potential Liquidity"). The Company currently believes that these
funds are sufficient for the acquisition of real estate-related investments,
repayments on borrowings and the payment of cash dividends as required for
Capstead's continued qualification as a REIT. 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. These
borrowings totaled approximately $3.1 billion at December 31, 2001. Capstead has
uncommitted repurchase facilities with investment banking firms to finance these
investments, subject to certain conditions. Interest rates on these borrowings
are generally based on overnight to 30-day London Interbank Offered Rate
("LIBOR") rates and related terms and conditions 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, credit quality and
liquidity conditions within the investment banking, mortgage finance and real
estate industries (see "Effects of Interest Rate Changes").
Borrowings secured by purchases of adjustable-rate commercial mortgage
assets more closely match the interest rate adjustment features of these
investments such that the Company anticipates it can earn more consistent
financing spreads and, as a result, experience less interest rate volatility
than experienced with the Company's other mortgage investments. These
borrowings, which generally have longer initial maturities than borrowings
secured by Agency Securities and may feature renewal options, totaled
approximately $152 million at December 31, 2001. Should Capstead make
significant additional investments in credit-sensitive real estate-related
assets, it is anticipated that it 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").
CMO borrowings totaled approximately $2.2 billion at December 31, 2001 and
are secured by CMO collateral pledged to the related indentures. As such,
recourse is limited to this collateral and therefore has a limited impact on
Capstead's liquidity and capital resources. The maturity of each CMO series is
affected by mortgage prepayments and clean-up calls.
Borrowings from sources such as commercial banks may be used to finance
other real estate-related investments the Company may make in 2002. The terms
and conditions of such borrowings will be negotiated on a
transaction-by-transaction basis and can be expected to be similar to the terms
and conditions on the Company's borrowings secured by commercial mortgage
assets.
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 can
reasonably be expected to have on future earnings. All mortgage assets and
Derivatives held, if any, are included in this analysis. The sensitivity of
Other revenue (expense) to changes in interest rates is included as well,
although no asset sales are assumed. The model incorporates management
assumptions regarding the level of mortgage prepayments for a given interest
rate change using market-based estimates of prepayment speeds for purposes of
amortizing purchase premiums and CMO bond discounts. These assumptions are
developed through a combination of historical analysis and future expected
pricing behavior. This analysis
illustrates that at December 31, 2001, Capstead's earnings were less sensitive
to changes in interest rates than as of the previous year-end. This is primarily
the result of runoff of the Company's investment portfolios experienced during
2001. As of December 31, 2001, Capstead had the following estimated earnings
sensitivity profile (dollars in thousands):
<Table>
<Caption>
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, 2001 1.87% 5.05% $12,380 $18,023 $3,196 $(14,771)
December 31, 2000 6.56 5.12 18,344 23,447 4,145 (22,665)
</Table>
* 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. There can be
no assurance 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.
Income simulation modeling is the 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 mortgage
prepayment rates, 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 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 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 only a portion
of the ARM loans underlying the Company's securities reset each month, and the
terms of an ARM loan 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 2001, and as is currently anticipated in 2002, declines
in these indices during periods of relatively low 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, earnings could
be adversely affected. 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, 2001 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 2001, and to some extent is
expected in 2002, 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 are not reinvested or cannot be
reinvested at a rate of interest at least equal to the rate previously earned on
that capital, earnings may be adversely affected. There can be no assurance that
suitable investments at attractive pricing will be available on a timely basis
to replace runoff as it occurs or that the current composition of investments
(consisting primarily of ARM Agency Securities) will be maintained.
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 2001, and to some extent is
expected in 2002, during periods of relatively low mortgage interest rates,
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.
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 2000, asset sales may become
prudent to shift the Company's investment focus. During periods of rising
interest rates or contracting market liquidity, mortgage asset values can
decline leading to increased margin calls, reducing the Company's liquidity. A
margin call means that a lender requires a borrower to pledge additional
collateral to re-establish the agreed-upon ratio of the value of the collateral
to the amount of the borrowing. If the Company is unable or unwilling to pledge
additional collateral, lenders can liquidate the collateral under adverse market
conditions, likely resulting in losses.
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 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 residential 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
mortgages, in instances of default the Company may incur losses if proceeds from
sales of the underlying residential collateral are less than the unpaid
principal balances of the residential mortgage loans and related foreclosure
costs. However, with residential mortgages 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
mortgages, 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 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 lower credit ratings, higher yields 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 even lower credit ratings and higher yields 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 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.