CAPSTEAD MORTGAGE CORPORATION CONDITION AND RESULTS OF OPERATIONS
FINANCIAL CONDITIONOverview
Capstead operates as a self-managed REIT earning income from investing in a leveraged portfolio of residential mortgage pass-through securities primarily consisting of relatively short-durationARM Agency Securities , which reset to more current interest rates within a relatively short period of time and are considered to have limited, if any, credit risk. By investing inARM Agency Securities , the Company is positioned to benefit from future recoveries in financing spreads that typically contract during periods of rising interest rates and to experience smaller fluctuations in portfolio values compared to leveraged portfolios containing a significant amount of fixed-rate mortgage securities. Capstead reported for GAAP purposes net income of$19 million , representing$0.15 per diluted common share for the quarter endedMarch 31, 2021 . The Company reported core earnings of$17 million or$0.13 per diluted common share for the quarter endedMarch 31, 2021 . See "Reconciliation of GAAP and non-GAAP Financial Measures" for more information on core earnings. GAAP and core earnings benefited from lower secured borrowings rates primarily due to the continued impact of the 150 basis points in reductions in the Fed Funds rate inMarch 2020 and favorable terms on new interest rate swap agreements entered into throughout 2020. These benefits more than offset lower portfolio yields due to lower coupon interest rates on loans underlying the Company'sARM Agency Securities and higher investment premium amortization due to higher mortgage prepayment levels as well as changes in lifetime prepayment estimates. Historically low interest rates have led to exceedingly high prepayment speeds across all mortgage products. The Company expects mortgage prepayment rates to peak as the second quarter progresses due in large part to increases in prevailing fixed-rate mortgage rates of nearly 50 basis points since year-end. If longer-term interest rates continue increasing, further declines in prepayments can be expected. Capstead finances its residential mortgage investments by leveraging its long-term investment capital with secured borrowings consisting of borrowings under repurchase arrangements with commercial banks and other financial institutions. Long-term investment capital declined$6 million during the first quarter of 2021 to$1.00 billion atMarch 31, 2021 , consisting of$653 million of common and$251 million of preferred stockholders' equity (recorded amounts), together with$99 million of unsecured borrowings maturing in 2035 and 2036. Capstead's residential mortgage portfolio decreased$532 million during the first quarter of 2021 to$7.41 billion atMarch 31, 2021 . Secured borrowings decreased$514 million to$6.81 billion as a result of lower portfolio balances. Portfolio leverage (secured borrowings divided by long-term investment capital) decreased to 6.79 to one atMarch 31, 2021 from 7.26 to one atDecember 31, 2020 . Management continuously evaluates portfolio leverage levels in light of changes in market conditions. -20- --------------------------------------------------------------------------------
COVID-19 Pandemic The near-total shutdown of theU.S. economy inMarch 2020 due to the COVID-19 pandemic and resulting destabilization of the fixed income markets led to widespread portfolio liquidations and losses for the mortgage REIT industry. During this period of extreme volatility, the Company sold a portion of its portfolio late inMarch 2020 and reduced its swap positions in order to ensure it had sufficient flexibility to meet future projected liquidity requirements while maintaining portfolio leverage at comfortable levels. During the crisis, the Company met all of its funding requirements. Intervention by theFederal Reserve beginning inMarch 2020 in the form of the buying of fixed-rateAgency Securities helped stabilize this key market sector leading to improved pricing levels for fixed-rateAgency Securities . While theFederal Reserve has not purchasedARM Agency Securities specifically, these actions contributed to improved pricing levels for mortgage assets in general and stabilized the operating environment for market participants including Capstead.
The Company's potential liquidity at
The Company continues to operate portions of its business continuity plan in response to the pandemic and has not experienced any operational disruption due to its small number of employees who are all able to work remotely. Management will continue to closely monitor the situation and adapt its response as necessary to avoid any operational disruptions.
Book Value per Common Share
Book value per share (total stockholders' equity, less liquidation preferences for outstanding shares of preferred stock, divided by outstanding shares of common stock) as ofMarch 31, 2021 was$6.66 per share, a decrease of$0.10 per share or 1.4% fromDecember 31, 2020 book value of$6.76 per share, primarily reflecting$0.22 in portfolio-related declines in value and$0.05 of declines related to capital activity, partially offset by derivative-related increases in value totaling$0.17 . All of Capstead's residential mortgage investments portfolio and all of its derivatives are recorded at fair value on the Company's balance sheet and are therefore included in the calculation of book value per common share. None of the Company's borrowings are recorded at fair value. See NOTE 8 to the consolidated financial statements (included under Item 1 of this report) for additional disclosures regarding fair values of financial instruments held or issued by the Company.
Residential Mortgage Investments
The following table illustrates Capstead's portfolio of residential mortgage
investments for the quarter ended
Residential mortgage investments, beginning of period
387,830
Investment premiums on acquisitions 16,394
Portfolio runoff (principal amount) (893,995 )
Investment premium amortization (20,887 )
Decrease in net unrealized gains on securities
classified as available-for-sale (21,483 ) Residential mortgage investments, end of period$ 7,405,411
Decrease in residential mortgage investments during the
period$ (532,141 ) -21-
-------------------------------------------------------------------------------- Capstead's investment strategy focuses on managing a portfolio of residential mortgage investments primarily consisting ofARM Agency Securities .Agency Securities are considered to have limited, if any, credit risk because the timely payment of principal and interest is guaranteed by Fannie Mae and Freddie Mac, which are government-sponsored enterprises, orGinnie Mae , which is an agency of the federal government. Federal government support for Fannie Mae and Freddie Mac has largely alleviated market concerns regarding the ability of Fannie Mae and Freddie Mac to fulfill their guarantee obligations. By focusing on investing inARM Agency Securities , changes in fair value caused by changes in interest rates are typically relatively modest compared to changes in fair value of longer-duration fixed-rate assets. Declines in fair value caused by increases in interest rates are generally recoverable in a relatively short period of time as coupon interest rates on the underlying mortgage loans reset to rates more reflective of the then-current interest rate environment. This investment strategy positions the Company to benefit from potential recoveries in financing spreads that typically contract during periods of rising interest rates. Capstead classifies its ARM securities based on the average length of time until the loans underlying each security reset to more current rates ("months-to-roll") (less than 18 months for "current-reset" ARM securities, and 18 months or greater for "longer-to-reset" ARM securities). The Company's ARM holdings featured the following characteristics atMarch 31, 2021 (dollars in thousands): Fully Average Average Average Months Amortized Net Indexed Net Periodic Lifetime To ARM Type Cost Basis (a) WAC (b) WAC (b) Margins (b) Caps (b) Caps (b) Roll Current-reset ARMs: Fannie Mae Agency Securities$ 2,097,018 2.29 % 1.91 % 1.65 % 2.88 % 6.97 % 6.8 Freddie Mac Agency Securities 718,627 2.52 2.01 1.74 2.14 6.11 8.2 Ginnie Mae Agency Securities 157,481 2.47 1.59 1.51 1.09 6.05 6.2 (40% of total) 2,973,126 2.35 1.92 1.66 2.61 6.71 7.1 Longer-to-reset ARMs: Fannie Mae Agency Securities 2,027,618 2.84 1.92 1.60 4.33 5.04 56.1 Freddie Mac Agency Securities 1,945,344 2.58 1.95 1.65 4.28 5.03 58.7 Ginnie Mae Agency Securities 396,255 3.56 1.57 1.50 1.00 5.00 34.9 (60% of total) 4,369,217 2.79 1.90 1.61 4.01 5.03 55.4$ 7,342,343 2.61 1.91 1.63 3.44 5.71 35.9 Gross WAC (rate paid by borrowers) (c) 3.25
(a) Amortized cost basis represents the Company's investment (unpaid principal
balance plus unamortized investment premiums) before unrealized gains and
losses. At
principal balance for the Company's ARM holdings was 103.76.
(b) Net WAC, or weighted average coupon, is the weighted average interest rate of
the mortgage loans underlying the indicated investments, net of servicing and
other fees as of the indicated date. Net WAC is expressed as a percentage
calculated on an annualized basis on the unpaid principal balances of the
mortgage loans underlying these investments. As such, it is similar to the
cash yield on the portfolio which is calculated using amortized cost
basis. Fully indexed WAC represents the weighted average coupon upon one or
more resets using interest rate indexes and net margins as of the indicated
date. Average net margins represent the weighted average levels over the
underlying indexes that the portfolio can adjust to upon reset, usually
subject to initial, periodic and/or lifetime caps on the amount of such
adjustments during any single interest rate adjustment period and over the
contractual term of the underlying loans.
ARM securities with initial fixed-rate periods of five years or longertypically have either 200 or 500 basis point initial caps with 200 basis
point periodic caps. Additionally, certain ARM securities held by the Company
are subject only to lifetime caps or are not subject to a cap. Nearly all ARM
securities held by the Company have lifetime floors equal to their net
margins. For presentation purposes, average periodic caps in the table above
reflect initial caps until after an ARM security has reached its initial
reset date and lifetime caps, less the current net WAC, for ARM securities
subject only to lifetime caps. At quarter-end, 73% of current-reset ARMs were
subject to periodic caps averaging 1.91%; 19% were subject to initial caps
averaging 3.14%; and 8% were subject to lifetime caps averaging 7.92%. All
longer-to-reset ARM securities at
caps.
(c) Gross WAC is the weighted average interest rate of the mortgage loans
underlying the indicated investments, including servicing and other fees paid
by borrowers, as of the indicated balance sheet date.
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-------------------------------------------------------------------------------- ARM securities held by Capstead are backed by mortgage loans that have coupon interest rates that adjust at least annually to more current interest rates or begin doing so after an initial fixed-rate period. These coupon interest rate adjustments are usually subject to periodic and lifetime limits, or caps, on the amount of such adjustments during any single interest rate adjustment period and over the contractual term of the underlying loans. After the initial fixed-rate period, if applicable, the coupon interest rates of mortgage loans underlying the Company's ARM securities typically adjust either (a) annually based on specified margins over the one-yearLondon interbank offered rate ("LIBOR") or the one-year Constant MaturityU.S. Treasury Note Rate ("CMT"), (b) semiannually based on specified margins over six-month LIBOR, or (c) monthly based on specified margins over indices such as one-month LIBOR, theEleventh District Federal ReserveBank Cost of Funds Index, or over a rolling twelve month average of the one-year CMT index. Fannie Mae and Freddie Mac began accepting ARM loans based on the Secured Overnight Financing Rate ("SOFR") inAugust 2020 and stopped accepting LIBOR-based ARM loans afterDecember 2020 due to the scheduled discontinuation of LIBOR inDecember 2021 . The Company expects to continue investing inAgency ARM Securities backed by a variety of indices including new SOFR-based ARM securities. Approximately 17% of the Company's current-reset ARM securities are scheduled to reset in rate within three months, 38% are scheduled to reset in rate between four and six months, 31% are scheduled to reset in rate between seven and 12 months, and 14% are scheduled to reset in rate between 13 and 18 months. The Company's current-reset ARM securities include$556 million (approximately 19% of the total current-reset ARM securities, with average net WACs of 2.77% and fully-indexed WACs of 1.93%) that will reset in rate for the first time in less than 18 months based on indices in effect atMarch 31, 2021 . After consideration of any applicable initial fixed-rate periods, atMarch 31, 2021 approximately 90%, 5% and 3% of the Company's ARM securities were backed by mortgage loans that reset annually, semi-annually and monthly, respectively, while approximately 2% reset every five years. Approximately 2% of the Company's ARM securities were backed by interest-only loans, with remaining interest-only payment periods averaging 10 months atMarch 31, 2021 . All percentages are based on averages of the characteristics of mortgage loans underlying each security and calculated using unpaid principal balances as of the indicated date.
Secured Borrowings and Related Derivatives Held for Hedging Purposes
Capstead finances its residential mortgage investments by leveraging its long-term investment capital with secured borrowings consisting of borrowings under repurchase arrangements with commercial banks and other financial institutions that involve the sale and a simultaneous agreement to repurchase the transferred assets at a future date and are accounted for as financings. The Company maintains the beneficial interest in the specific securities pledged during the term of each repurchase arrangement and receives the related principal and interest payments. The terms and conditions of secured borrowings are negotiated on a transaction-by-transaction basis when each such borrowing is initiated or renewed. None of the Company's counterparties are obligated to renew or otherwise enter into new borrowings at the conclusion of existing borrowings. Collateral requirements in excess of amounts borrowed (referred to as "haircuts") averaged 4.3% of the fair value of pledged residential mortgage pass-through securities atMarch 31, 2021 , relatively consistent with prior year. After considering haircuts and related interest receivable on the collateral, as well as interest payable on these borrowings, the Company had$369 million of capital at risk with its lending counterparties atMarch 31, 2021 . The Company did not have capital at risk with any single counterparty exceeding 5% of total stockholders' equity atMarch 31, 2021 . Secured borrowing rates are fixed based on prevailing rates corresponding to the terms of the borrowings. Interest may be paid monthly or at the termination of a borrowing at which time the Company may enter into a new borrowing at prevailing haircuts and rates with the same counterparty or repay that counterparty and negotiate financing with a different counterparty. When the fair value of pledged -23- -------------------------------------------------------------------------------- securities declines due to changes in market conditions or the publishing of monthly security pay-down factors, lenders typically require the Company to post additional securities as collateral, pay down borrowings or fund cash margin accounts with the counterparties in order to re-establish the agreed-upon collateral requirements, referred to as margin calls. Conversely, if collateral fair values increase, lenders are required to release collateral back to the Company pursuant to Company-issued margin calls. As ofMarch 31, 2021 , the Company's secured borrowings totaled$6.81 billion with 19 counterparties at average rates of 0.17%, before the effects of currently-paying interest rate swap agreements. The Company typically uses interest rate swap agreements with terms between 18 and 36 months and variable rate receipts based on SOFR (previously LIBOR) or Fed Funds to help mitigate exposure to rising short-term interest rates. During the first quarter of 2021, the Company increased its swap positions by$250 million notional amount. At quarter-end the Company held$3.22 billion notional amount of these derivatives at fixed rates averaging 0.06% with contract expirations occurring at various dates through the second quarter of 2024 and a weighted average expiration of 20 months. Including the effects of these derivatives, the Company's residential mortgage investments and secured borrowings had estimated durations atMarch 31, 2021 of 13 months and 9¾ months, respectively, for a net duration gap of approximately 3¼ months - see "Interest Rate Risk" for further information about the Company's sensitivity to changes in market interest rates. The Company intends to continue to manage interest rate risk associated with holding and financing its residential mortgage investments by utilizing suitable derivative financial instruments such as interest rate swap agreements, Eurodollar futures and longer-maturity secured borrowings, if available at attractive rates and terms.
Utilization of
Capstead's investment strategy involves managing an appropriately leveraged portfolio ofARM Agency Securities that management believes can produce attractive risk-adjusted returns over the long term, while reducing, but not eliminating, sensitivity to changes in interest rates. The potential liquidity inherent in the Company's unencumbered residential mortgage investments is as important as the actual level of cash and cash equivalents carried on the balance sheet because secured borrowings generally can be increased or decreased on a daily basis to meet cash flow requirements and otherwise manage capital resources efficiently. Potential liquidity is affected by, among other factors:
• current portfolio leverage levels,
• changes in market value of assets pledged and derivatives held for hedging
purposes as determined by lending and swap counterparties,
• mortgage prepayment levels,
• availability of borrowings under repurchase arrangements with lending
counterparties,
• collateral requirements of lending and derivative counterparties, and
• general conditions in the commercial banking and mortgage finance industries.
-24-
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Capstead's utilization of its long-term investment capital and its estimated
potential liquidity were as follows as of
Secured Capital Potential Portfolio
Investments (a) Borrowings Employed Liquidity (b) Leverage
Residential mortgage investments $ 7,405,411 $ 6,805,061 $ 600,350 $ 280,797
Cash collateral receivable from
derivative counterparties, net (c) 34,724 -
Other assets, net of other liabilities 367,138 259,233
Balances as of March 31, 2021: $ 7,405,411 $ 6,805,061
Balances as of
$ 1,008,656 $ 524,037 7.26:1
(a) Investments are stated at balance sheet carrying amounts, which generally
reflect estimated fair value as of the indicated dates.
(b) Potential liquidity is based on maximum amounts of borrowings available under
existing uncommitted financing arrangements considering management's estimate
of the fair value of residential mortgage investments held as of the
indicated dates adjusted for other sources of liquidity such as cash and cash
equivalents and cash collateral pledged to secured borrowing counterparties.
(c) Cash collateral receivable from derivative counterparties is presented net of
cash collateral payable to derivative counterparties, if applicable, and the
fair value of interest rate swap positions as of the indicated date.
In order to efficiently manage its liquidity and capital resources, Capstead attempts to maintain sufficient liquidity reserves to fund borrowing and derivative margin calls under stressed market conditions, including margin calls resulting from monthly principal payments (remitted to the Company 20 to 45 days after any given month-end), as well as reasonably possible declines in the market value of pledged assets and derivative positions. Should market conditions deteriorate, management may reduce portfolio leverage and increase liquidity by raising new equity capital, selling mortgage securities and/or curtailing the replacement of portfolio runoff. Additionally, the Company routinely does business with a large number of lending counterparties, which bolsters financial flexibility to address challenging market conditions and limits exposure to any individual counterparty. In response to pricing and ARM supply pressures in the first quarter the Company reduced portfolio leverage by only replacing a portion of portfolio runoff. Future levels of portfolio leverage will be dependent on many factors, including the size and composition of the Company's investment portfolio (see "Liquidity and Capital Resources").
Reconciliation of GAAP and non-GAAP Financial Measures
Management believes the presentation of core earnings and core earnings per
common share, both non-GAAP financial measures, when analyzed in conjunction
with the Company's GAAP operating results, allows investors to more effectively
evaluate the Company's performance and provide investors management's view of
the Company's economic performance. The Company defines core earnings as GAAP
net income (loss) excluding (a) unrealized (gain) loss on derivative
instruments, (b) realized loss (gain) on termination of derivative instruments,
(c) amortization of unrealized (gain) loss of derivative instruments held at the
time of de-designation, and (d) realized loss (gain) on securities. The
Company's presentation of core earnings may not be comparable to
similarly-titled measures of other companies, who may use different
calculations.
-25-
--------------------------------------------------------------------------------The following reconciles GAAP net income (loss) and net income (loss) per diluted common share to core earnings and core earnings per common share:
Quarter Ended March 31
2021 2020
Amount Per Share Amount Per Share
Net income (loss) $ 18,942 $ 0.15 $ (204,653 ) $ (2.21 )
Unrealized (gain) loss onnon-designated derivative
instruments (2,228 ) (0.02 ) 56,182 0.59 Realized loss on termination of derivative instruments - - 100,565 1.06
Amortization of unrealized
gain, net of unrealized
losses on de-designated
derivative instruments 646 0.00 (103 ) (0.00 ) Realized loss on sale of investments - - 67,820 0.72 Core earnings$ 17,360 $ 0.13 $ 19,811 $ 0.16
Management believes that presenting financing spreads on residential mortgage investments, a non-GAAP financial measure, provides useful information for evaluating the performance of the Company's portfolio as opposed to total financing spreads because the non-GAAP measure speaks specifically to the performance of the Company's investment portfolio. The following reconciles these measures for the indicated periods:
Quarter Ended March 31
2021 2020
Total financing spreads 1.01 % 0.66 %
Impact of yields on other
interest-earning assets (a) 0.02 0.02Impact of borrowing rates on other
interest-paying liabilities (a) 0.11 0.05
Impact of amortization of unrealized
gain, net of unrealized losses on
de-designated Derivatives 0.04 (0.00 )
Impact of net interest cash flows on
non-designated Derivatives 0.00 0.04
Financing spreads on residential
mortgage investments 1.18 0.77
(a) Other interest-earning assets consist of overnight investments and cash
collateral receivable from derivative counterparties. Other interest-paying
liabilities consist of unsecured borrowings and, at times, cash collateral
payable to interest rate swap counterparties.
-26-
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RESULTS OF OPERATIONS
Quarter Ended
March 31
2021 2020Income statement data (in thousands, except per share data) Interest income on residential mortgage investments
$ 26,165 $ 69,207 Related interest expense (4,172 ) (45,256 ) 21,993 23,951 Other interest income (expense) (1,878 )
(1,497 )
20,115 22,454
Other (expense) income:
Gain (loss) on derivative instruments (net) 2,382 (155,739 )
Loss on sale of investments (net) - (67,820 )
Compensation-related expense (2,092 ) (2,204 )
Other general and administrative expense (1,465 ) (1,202 )
Miscellaneous other revenue (expense) 2 (142 )
(1,173 ) (227,107 )
Net income (loss) $ 18,942 $ (204,653 )
Net income (loss) per diluted common share $ 0.15 $ (2.21 )
Average diluted shares outstanding 96,230 94,897
Core earnings (a)$ 17,360 $ 19,811 Core earnings per diluted common share (a) 0.13
0.16
Key operating statistics (dollars in millions) Average yields: Residential mortgage investments 1.38 % 2.49 % Other interest-earning assets 0.04 1.14 Total average yields 1.36 2.47 Average borrowing rates: Secured borrowings (a)(b) 0.20 1.72 Unsecured borrowings 7.68 7.72 Total average borrowing rates 0.35 1.77 Average total financing spreads 1.01
0.66
Average financing spreads on residential mortgage investments (a) 1.18 0.77 Average CPR 37.12 26.71 Average balance information: Residential mortgage investments (cost basis)$ 7,579 $ 11,123 Other interest-earning assets 123
141
Secured borrowings 6,884
10,337
Unsecured borrowings (included in long-term
investment capital) 99
98
Long-term investment capital ("LTIC") 1,010 1,124
Operating costs as a percentage of average LTIC 1.43 % 1.22 % Return on average common equity capital (c) 7.68 7.77
(a) See "Reconciliation of GAAP and non-GAAP Financing Measures" for a
reconciliation of these financial measures and the Company's rationale for
using these non-GAAP financial measures.
(b) To better compare the components of financing spreads on residential mortgage
investments with prior periods, secured borrowing rates exclude the effects
of amortization of the net unrealized gains and losses included in
Accumulated other comprehensive income (loss) upon de-designation of related
derivatives held for hedging purposes of 0.04% and (0.00)%, and include net
interest cash flows on non-designated derivatives totaling 0.00% and 0.04%
for the quarters ended
(c) Calculated using core earnings less preferred dividends on an annualized
basis over average common equity for the period.
-27-
-------------------------------------------------------------------------------- Capstead reported for GAAP purposes net income of$19 million representing$0.15 per diluted common share for the quarter endedMarch 31, 2021 . This compares to a GAAP net loss of$205 million representing$(2.21) per diluted common share for the same period in 2020. GAAP net income was positively impacted by gains on derivatives of$2 million due to entering into more favorable swap agreements during 2020, as well as$156 million of derivative losses due to declining interest rates and losses on sales of investments of$68 million recognized during the same period in 2020. Capstead's core earnings, a non-GAAP financial measure, totaled$17 million or$0.13 per diluted common share for the quarter endedMarch 31, 2021 compared to core earnings of$20 million or$0.16 per diluted common share for the same period in 2020. Core earnings in the first quarter of 2021 benefited from lower borrowing rates while being negatively impacted by lower yields on residential mortgage investments and lower average portfolio balances. Interest income on residential mortgage investments was lower by$43 million for the quarter endedMarch 31, 2021 compared to the same period in 2020. Lower average yields drove$25 million of the decrease while lower average portfolio balances drove the remaining$18 million . Yields on residential mortgage investments averaged 1.38% for the quarter endedMarch 31, 2021 , a decrease of 111 basis points compared to the same period in 2020, primarily due to lower coupon interest rates on loans underlying the Company'sARM Agency Securities that have reset based on lower prevailing interest rates, as well as lower coupons on acquisitions and other changes in portfolio composition. Yields were also negatively impacted by higher premium amortization compared to the same period in 2020 due primarily to higher prepayment rates experienced on the portfolio and changes in prepayment estimates. Historically low interest rates have led to exceedingly high prepayment speeds across all mortgage products. While ARM securities are priced to incur higher prepayment speeds than fixed rate securities, and fixed rate securities have incurred higher percentage increases than ARM securities over previous levels, the Company's ARM securities have experienced elevated prepayment speeds ultimately hurting yields on its investments. The Company expects mortgage prepayment rates to peak as the second quarter progresses due in large part to increases in prevailing fixed-rate mortgage rates of nearly 50 basis points since year-end. If longer-term interest rates continue increasing, further declines in prepayments can be expected.
Interest expense on secured borrowings was lower by
Secured borrowing rates, after adjusting for hedging activities, decreased 152 basis points for the quarter endedMarch 31, 2021 compared to the same period in 2020 to average 0.20%. Market conditions contributed to lower borrowing rates, including 150 basis points in reductions to the Federal Funds rate inMarch 2020 . Average fixed-rate swap payment rates were four basis points for the quarter endedMarch 31, 2021 compared to 162 basis points for the same period in 2020. This decline was largely due to efforts to reposition the swap portfolio to take advantage of declining market interest rates in 2020. Currently-paying swap notional amounts were lower, averaging$2.99 billion for the quarter endedMarch 31, 2021 compared to$7.10 billion for the same period in 2020. Future secured borrowing rates will be dependent on market conditions, including overall levels of market interest rates as well as the availability of longer-maturity borrowings and interest rate swap agreements at attractive rates.
Total operating costs, which include Compensation-related expense and Other
general and administrative expense, were higher by
-28-
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liquidity and capital resources
Capstead's primary sources of funds are secured borrowings and monthly principal
and interest payments on its investments. Other sources of funds may include
proceeds from debt and equity offerings and asset sales. The timing, manner,
price and amount of any future common and preferred issuances and any common or
preferred stock repurchases will be made in the open market at the Company's
discretion, subject to economic and market conditions, stock price, compliance
with federal securities laws and tax regulations as well as blackout periods
associated with the dissemination of important Company-specific news.
The Company generally uses its liquidity to pay down secured borrowings to
reduce borrowing costs and otherwise efficiently manage its long-term investment
capital. Because the level of these borrowings can generally be adjusted on a
daily basis, the Company's potential liquidity inherent in its unencumbered
residential mortgage investments is as important as the level of cash and cash
equivalents carried on the balance sheet. The table included under "Utilization
of Long-term Investment Capital and Potential Liquidity" illustrates
management's estimate of additional funds potentially available to the Company
at March 31, 2021 . The discussion accompanying this table and under "COVID-19
Pandemic" provides insight into the Company's current liquidity position and
perspective on what level of portfolio leverage to employ under current market
conditions. The Company currently believes that it has sufficient liquidity and
capital resources available for the acquisition of additional investments,
repayments on borrowings and the payment of cash dividends as required for the
Company's continued qualification as a REIT.
Capstead finances its residential mortgage investments by borrowing under repurchase arrangements, the terms and conditions of which are negotiated on a transaction-by-transaction basis, when each such borrowing is initiated or renewed.
Future borrowings are dependent upon the willingness of lenders to participate in the financing ofAgency Securities , lender collateral requirements and the lenders' determination of the fair value of the securities pledged as collateral, which fluctuates with changes in interest rates and liquidity conditions within the commercial banking and mortgage finance industries. None of the Company's borrowing counterparties are obligated to renew or otherwise enter into new borrowings at the conclusion of existing borrowings. Secured borrowings totaled$6.81 billion atMarch 31, 2021 with$6.31 billion maturing within 90 days. Secured borrowings began the year at$7.32 billion and averaged$6.88 billion during the quarter endedMarch 31, 2021 . Average secured borrowings can differ from period-end balances for a number of reasons including portfolio growth or contraction, as well as differences in the timing of portfolio acquisitions relative to portfolio runoff. To help mitigate exposure to rising short-term interest rates, the Company uses derivatives supplemented with longer-maturity secured borrowings when available at attractive rates and terms. At quarter-end the Company held$3.22 billion notional amount of portfolio financing-related interest rate swap agreements with contract expirations occurring at various dates through the second quarter of 2024 and a weighted average expiration of 20 months. The Company also holds swap agreements effectively locking in fixed rates of interest during the 20-year floating rate terms of the Company's$100 million face amount of unsecured borrowings that mature in 2035 and 2036. The Company intends to continue to utilize suitable derivatives such as interest rate swap agreements or other derivatives and longer-maturity secured borrowings to manage interest rate risk when available at attractive rates and terms.
Interest Rate Risk
Because Capstead's residential mortgage investments consist almost entirely ofAgency Securities , which are considered to have limited, if any, credit risk, interest rate risk is the primary market risk faced by the Company. Interest rate risk is highly sensitive to a number of factors, including economic conditions, -29- -------------------------------------------------------------------------------- government fiscal policy, central bank monetary policy and banking regulation. By focusing on investing in relatively short-durationARM Agency Securities , declines in fair value caused by increases in interest rates are typically relatively modest compared to investments in longer-duration fixed-rate assets. These declines can be recovered in a relatively short period of time as coupon interest rates on the underlying mortgage loans reset to rates more reflective of the then-current interest rate environment. This strategy also positions the Company to benefit from future recoveries in financing spreads that typically contract during periods of rising interest rates. Derivatives and longer-maturity secured borrowings transactions lengthen the effective duration of the Company's secured borrowings to more closely match the duration of its portfolio of residential mortgage investments. Including the effects of derivatives held to hedge changes in secured borrowing rates, atMarch 31, 2021 the Company's residential mortgage investments and secured borrowings had estimated durations of approximately 13 months and 9¾ months, respectively, for a net duration gap of approximately 3¼ months. The Company intends to continue to manage interest rate risk associated with holding and financing its residential mortgage investments by utilizing suitable interest rate swap agreements or other derivatives and longer-maturity secured borrowings, if available at attractive rates and terms. Capstead performs sensitivity analyses to estimate the effects that specific interest rate changes can reasonably be expected to have on net interest margins and portfolio values. All investments, secured borrowings and related derivatives held are included in these analyses. For net interest margin modeling purposes, the model incorporates management's assumptions for mortgage prepayment levels for a given interest rate change using market-based estimates of prepayment speeds for the purpose of amortizing investment premiums and reinvesting portfolio runoff. These assumptions are developed through a combination of historical analysis and expectations for future pricing behavior under normal market conditions unaffected by changes in market liquidity. For portfolio valuation modeling purposes, a static portfolio is assumed. This model is the primary tool used by management to assess the direction and magnitude of changes in net interest margins and portfolio values resulting solely from changes in interest rates. Key modeling assumptions include mortgage prepayment speeds, adequate levels of market liquidity, current market conditions, index floors, and portfolio leverage levels. These assumptions are inherently uncertain and, as a result, modeling cannot precisely estimate the impact of higher or lower interest rates. Actual results will differ from simulated results due to the timing, magnitude and frequency of interest rate changes, other changes in market conditions, changes in management strategies and other factors. -30-
-------------------------------------------------------------------------------- The table below reflects the estimated impact of instantaneous parallel shifts in the yield curve on net interest margins and the fair value of Capstead's portfolio of residential mortgage investments and related derivatives atMarch 31, 2021 andDecember 31, 2020 , subject to the modeling parameters described above. Federal 10-year U.S. Funds Treasury Down Down Up Up Rate Rate 1.00% 0.50% 0.50% 1.00%
Projected 12-month percentage
change in net interest margins: (a)(b) March 31, 2021 0.00-0.25 % 1.74 % 10.0 % 4.4 % (2.4 )% (7.0 )% December 31, 2020 0.00-0.25 0.92 11.3 5.0 (3.4 ) (9.0 ) Projected percentage change in portfolio and related derivative values: (a) March 31, 2021 0.00-0.25 1.74 (0.2 ) 0.0 (0.4 ) (0.5 ) December 31, 2020 0.00-0.25 0.92 (0.1 ) 0.0 (0.4 ) (0.7 )
(a) Sensitivity of net interest margins as well as portfolio and related
derivative values to changes in interest rates is determined relative to the
actual rates at the applicable date. Note that the projected 12-month net
interest margin 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, if
investments made will behave in the same fashion as assets currently held or
if management will choose to replace runoff with such assets.
(b) The model assumes a floor on all pertinent market indices of 0.00% except the
Federal Funds rate and borrowing rates, which have no assumed floor.
CRITICAL ACCOUNTING POLICIES
Management's discussion and analysis of financial condition and results of
operations is based upon Capstead's consolidated financial statements, which
have been prepared in accordance with accounting principles generally accepted
in the United States . The preparation of these financial statements requires the
use of estimates and judgments that can affect the reported amounts of assets,
liabilities (including contingencies), revenues and expenses, as well as related
disclosures. These estimates are based on available internal and market
information and appropriate valuation methodologies believed to be reasonable
under the circumstances, the results of which form the basis for making
judgments about the expected useful lives and carrying values of assets and
liabilities which can materially affect the determination of net income and book
value per common share. Actual results may differ from these estimates under
different assumptions or conditions.
Management believes the following are critical accounting policies in the preparation of Capstead's consolidated financial statements that involve the use of estimates requiring considerable judgment:
• Amortization of investment premiums on residential mortgage investments -
Investment premiums on residential mortgage investments are recognized in
earnings as adjustments to interest income by the interest method over the
estimated lives of the related assets. Amortization is affected by actual
portfolio runoff (scheduled and unscheduled principal paydowns) and by
estimates and judgments related to future levels of mortgage prepayments that
may be necessary to achieve the required effective yield over the estimated
life of the related investment.
Mortgage prepayment expectations can change based on how current and projected
changes in interest rates impact the economic attractiveness of mortgage
refinance opportunities, if available, and other factors such as lending
industry underwriting practices and capacity constraints, regulatory changes,
borrower credit profiles and the health of the economy and housing
markets. Management
-31-
--------------------------------------------------------------------------------estimates future mortgage prepayments based on these factors and past experiences with specific investments within the portfolio. Should actual prepayment rates differ materially from these estimates, investment premiums would be expensed at a different pace.
• Fair value and impairment accounting for residential mortgage investments -
Nearly all of Capstead's residential mortgage investments are held in the
form of mortgage securities that are classified as available-for-sale and
recorded at fair value on the balance sheet with unrealized gains and losses
recorded in Stockholders' equity as a component of Accumulated other
comprehensive income. Fair values fluctuate with current and projected
changes in interest rates, prepayment expectations and other factors such as
market liquidity conditions and the perceived credit quality of Agency
Securities. Judgment is required to interpret market data and develop
estimated fair values, particularly in circumstances of deteriorating credit
quality and market liquidity. See NOTE 8 to the consolidated financial
statements (included under Item 1 of this report) for discussion of how
Capstead values its residential mortgage investments.
Generally, gains or losses are recognized in earnings only if securities are
sold; however, if a decline in fair value of a mortgage security below its
amortized cost occurs, the difference between amortized cost and fair value
would be recognized in earnings as a component of Other (expense) income if the
decline was credit-related or it was determined to be more likely than not that
the Company will incur a loss via an asset sale.
• Accounting for derivative instruments - Derivatives are recorded as assets or
liabilities and carried at fair value. Fair values fluctuate with current and
projected changes in interest rates and other factors such as the Company's
and its counterparties' nonperformance risk. Judgment is required to develop
estimated fair values.
The accounting for changes in fair value of each derivative held depends on
whether it has been designated as an accounting hedge, as well as the type of
hedging relationship identified. To qualify as a cash flow hedge for accounting
purposes, at the inception of the hedge relationship the Company must anticipate
and document that the hedge relationship will be highly effective and must
monitor ongoing effectiveness on at least a quarterly basis. As long as the
hedge relationship remains highly effective, changes in fair value of the
derivative are recorded in Accumulated other comprehensive income. Changes in
fair value of derivatives not held as accounting hedges, or for which the hedge
relationship is deemed to no longer be highly effective and as a result hedge
accounting is terminated, are recorded in earnings as a component of Other
(expense) income.
The Company uses derivatives primarily in the form of interest rate swap
agreements to hedge the variability in borrowing rates on its secured and
unsecured borrowings. For derivatives designated as accounting hedges, fixed
interest payments and variable interest receipts are recorded as an adjustment
to interest expense on the related designated borrowings. For derivatives not
designated as accounting hedges, fixed interest payments and variable interest
receipts are recorded as a component of Other (expense) income. For derivatives
initially designated as an accounting hedge and subsequently de-designated, any
unrealized gain or loss included in Accumulated other comprehensive income at
the time of de-designation is amortized as an adjustment to interest expense on
the related borrowings over the remaining term of the derivatives. See NOTE 6
to the consolidated financial statements (included under Item 1 of this report)
and "Financial Condition - Secured Borrowings" for additional information
regarding the Company's current use of derivatives and its related risk
management policies.
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STATEMENT CONCERNING FORWARD-LOOKING STATEMENTS
This document contains "forward-looking statements" within the meaning of the
Private Securities Litigation Reform Act of 1995. Forward-looking statements
include, without limitation, any statement that may predict, forecast, indicate
or imply future results, performance or achievements, and may contain the words
"believe," "anticipate," "expect," "estimate," "intend," "will be," "will likely
continue," "will likely result," or words or phrases of similar
meaning. Forward-looking statements are based largely on the expectations of
management and are subject to a number of risks and uncertainties including, but
not limited to, the following:
• fluctuations in interest rates and levels of mortgage prepayments;
• changes in market conditions as a result of federal corporate and individual
income tax reform, federal government fiscal challenges and
monetary policy, including policy regarding its holdings of Agency and
• liquidity of secondary markets and credit markets, including the availability
of financing at reasonable levels and terms to support investing on a
leveraged basis;
• the impact of differing levels of leverage employed;
• changes in legislation or regulation affecting
federal government agencies and related guarantees;
• changes in our strategy, operation or business model;
• deterioration in credit quality and ratings of existing or future issuances
of
• the effectiveness of risk management strategies;
• the availability of suitable qualifying investments from both an investment
return and regulatory perspective;
• the availability of new investment capital;
• the ability to maintain real estate investment trust ("REIT") status for
federal income tax purposes;
• changes in legislation or regulation affecting exemptions for mortgage REITs
from regulation under the Investment Company Act of 1940;
• negative impacts from the ongoing novel coronavirus (COVID-19) pandemic
including on the
condition and earnings;
• other changes in legislation or regulation affecting the mortgage and banking
industries; and
• changes in general economic conditions, increases in costs and other general
competitive factors.
In light of the ongoing COVID-19 pandemic, several of the risks and uncertainties described above are more likely to occur and/or the potential impact therefrom is harder to estimate. In particular, the impact of COVID-19 on fluctuations in interest rates and levels of mortgage prepayments, liquidity of secondary markets and credit markets, including the availability of financing at reasonable levels and terms to support investing on a leveraged basis, and changes in general economic conditions, are especially unclear at this time. Given this unprecedented uncertainty, actual results could differ materially from those anticipated or implied in the forward-looking statements included herein. In addition to the above considerations, actual results and liquidity are affected by other risks and uncertainties which could cause actual results to be significantly different from those expressed or implied by any forward-looking statements included herein. It is not possible to identify all of the risks, uncertainties and other factors that may affect future results. In light of these risks and uncertainties, the forward-looking events and circumstances discussed herein may not occur and actual results could differ materially from those anticipated or implied in the forward-looking statements. Forward-looking statements speak only as of the date the statement is made and the Company undertakes no obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Accordingly, readers of this document are cautioned not to place undue reliance on any forward-looking statements included herein. For a further discussion of these and other factors that could impact our future results and performance, see "Risk Factors" under Part I, Item 1A of our Annual Report on Form 10-K for the year endedDecember 31, 2020 , filed with theU.S. Securities and Exchange Commission (the "SEC") onFebruary 19, 2021 , as well as our subsequent filings with theSEC . -33-
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