##### 



Exhibit 13 Capstead Mortgage Corporation Reports on Corporate Governance andReports of Independent Registered Public Accounting Firm Report of Management on Effectiveness of Internal Control
Over Financial Reporting Management of Capstead Mortgage Corporation (Capstead or the Company) is responsible
for establishing and maintaining adequate internal control over financial reporting, as such term
is defined in Rule 13a  15(f) promulgated under the Securities Exchange Act of 1934, as amended
(the Exchange Act). Under the supervision and with the participation of management, including the
Chief Executive Officer (CEO) and Chief Financial Officer (CFO), we conducted an evaluation of
the effectiveness of the internal control over financial reporting based on the framework
established in Internal Control  Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO). Based on our evaluation under the COSO
framework, it is managements assessment that the Company maintained effective internal control
over financial reporting as of December 31, 2004. Capsteads independent registered public accounting firm, Ernst & Young LLP, has issued an
attestation report on managements assessment of internal control over financial reporting which is
included in this Annual Report. Report of Management on Effectiveness of Disclosure Controls and Procedures Under the supervision and with the participation of management, including the CEO and
CFO, an evaluation of Capsteads disclosure controls and procedures as defined under Exchange Act
Rule 13a-15(e) was conducted. Based on this evaluation, the Companys management, including the
CEO and CFO, concluded that the Companys disclosure controls and procedures were effective as of
December 31, 2004. Related Certifications by Management Certifications by the CEO and CFO pursuant to Section 302(a) of the Sarbanes-Oxley Act of
2002 pertaining to the completeness and fairness of the information contained in Capsteads annual
report on Form 10-K for the year ended December 31, 2004 and the Companys system of internal
controls over financial reporting and disclosure controls and procedures are included as exhibits
to the annual report on Form 10-K. This report, as well as the Companys other filings with the
Securities and Exchange Commission, are available free of charge on the Companys website at
www.capstead.com. On May 17, 2004 Capsteads CEO certified, pursuant to Section 303A.12(a) of the New York Stock
Exchange (NYSE) Listed Company Manual, that he was not aware of any violation by the Company of
NYSE corporate governance listing standards. This certification is made annually with the NYSE
within thirty days after the Companys annual meeting of stockholders. 3




---



##### 



Capstead Mortgage Corporation Report of Independent Registered Public Accounting Firm on
Audit of Managements Assessment of Internal Control Over Financial Reporting Stockholders and Board of Directors
Capstead Mortgage Corporation We have audited managements assessment, included in the accompanying Report of Management on
Effectiveness of Internal Control Over Financial Reporting, that Capstead Mortgage Corporation (the
Company) maintained effective internal control over financial reporting as of December 31, 2004,
based on criteria established in Internal Control  Integrated Framework issued by the Committee of
Sponsoring Organizations of the Treadway Commission (the COSO criteria). The Companys management
is responsible for maintaining effective internal control over financial reporting and for its
assessment of the effectiveness of internal control over financial reporting. Our responsibility is
to express an opinion on managements assessment and an opinion on the effectiveness of the
Companys internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting
Oversight Board (United States). Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether effective internal control over financial reporting was
maintained in all material respects. Our audit included obtaining an understanding of internal
control over financial reporting, evaluating managements assessment, testing and evaluating the
design and operating effectiveness of internal control, and performing such other procedures as we
considered necessary in the circumstances. We believe that our audit provides a reasonable basis
for our opinion. A companys internal control over financial reporting is a process designed to provide
reasonable assurance regarding the reliability of financial reporting and the preparation of
financial statements for external purposes in accordance with generally accepted accounting
principles. A companys internal control over financial reporting includes those policies and
procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately
and fairly reflect the transactions and dispositions of the assets of the company; (2) provide
reasonable assurance that transactions are recorded as necessary to permit preparation of financial
statements in accordance with generally accepted accounting principles, and that receipts and
expenditures of the company are being made only in accordance with authorizations of management and
directors of the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the companys assets that could have
a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent
or detect misstatements. Also, projections of any evaluation of effectiveness to future periods
are subject to the risk that controls may become inadequate because of changes in conditions, or
that the degree of compliance with the policies or procedures may deteriorate. In our opinion, managements assessment that the Company maintained effective internal control
over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based
on the COSO criteria. Also, in our opinion, the Company maintained, in all material respects,
effective internal control over financial reporting as of December 31, 2004, based on the COSO
criteria. We have also audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the consolidated balance sheets of Capstead Mortgage Corporation
as of December 31, 2004 and 2003, and the related consolidated statements of income, stockholders
equity, and cash flows for each of the three years in the period ended December 31, 2004 of
Capstead Mortgage Corporation and our report dated February 22, 2005 expressed an unqualified
opinion thereon. Dallas, Texas
February 22, 2005 4




---



##### 



Capstead Mortgage Corporation Report of Independent Registered Public Accounting Firm on
Audit of the Consolidated Financial Statements Stockholders and Board of Directors
Capstead Mortgage Corporation We have audited the accompanying consolidated balance sheets of Capstead Mortgage Corporation
as of December 31, 2004 and 2003, and the related consolidated statements of income, stockholders
equity, and cash flows for each of the three years in the period ended December 31, 2004. 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 the standards of the Public Company Accounting
Oversight Board (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, 2004
and 2003, and the consolidated results of its operations and its cash flows for each of the three
years in the period ended December 31, 2004, in conformity with United States generally accepted
accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the effectiveness of Capstead Mortgage Corporations internal
control over financial reporting as of December 31, 2004, based on criteria established in Internal
Control  Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway
Commission and our report dated February 22, 2005 expressed an unqualified opinion thereon. Dallas, Texas
February 22, 2005 5




---



##### 



Capstead Mortgage Corporation Consolidated Statements of Income (In thousands, except per share amounts) Year Ended December 312004
    
    
    2003
    
    
    2002Interest income:Mortgage securities and similar investments
    
    $
    84,355
    
    
    $
    85,343
    
    
    $
    150,302CMO collateral
    
    
    6,766
    
    
    
    34,101
    
    
    
    114,353Total interest income
    
    
    91,121
    
    
    
    119,444
    
    
    
    264,655Interest and related expense:Repurchase arrangements and similar borrowings
    
    
    38,695
    
    
    
    24,606
    
    
    
    48,329CMO borrowings
    
    
    6,012
    
    
    
    33,926
    
    
    
    116,069Mortgage insurance and other
    
    
    232
    
    
    
    392
    
    
    
    596Total interest and related expense
    
    
    44,939
    
    
    
    58,924
    
    
    
    164,994Net margin on financial assets
    
    
    46,182
    
    
    
    60,520
    
    
    
    99,661Real estate lease income
    
    
    10,116
    
    
    
    10,028
    
    
    
    8,170Real estate-related expense:Interest
    
    
    4,472
    
    
    
    4,327
    
    
    
    4,750Depreciation
    
    
    3,708
    
    
    
    3,708
    
    
    
    2,543Total real estate-related expense
    
    
    8,180
    
    
    
    8,035
    
    
    
    7,293Net margin on real estate held for lease
    
    
    1,936
    
    
    
    1,993
    
    
    
    877Other revenue (expense):Gain on asset sales and CMO redemptions
    
    
    
    
    
    
    4,560
    
    
    
    4,725CMO administration and other
    
    
    813
    
    
    
    1,784
    
    
    
    2,429Incentive fee paid to former affiliate
    
    
    
    
    
    
    (500
    )
    
    
    (4,982
    )Other operating expense
    
    
    (7,126
    )
    
    
    (7,698
    )
    
    
    (6,587
    )Total other revenue (expense)
    
    
    (6,313
    )
    
    
    (1,854
    )
    
    
    (4,415
    )Net income
    
    $
    41,805
    
    
    $
    60,659
    
    
    $
    96,123Net income
    
    $
    41,805
    
    
    $
    60,659
    
    
    $
    96,123Less cash dividends paid on preferred stock
    
    
    (20,259
    )
    
    
    (20,273
    )
    
    
    (20,362
    )Net income available to common stockholders
    
    $
    21,546
    
    
    $
    40,386
    
    
    $
    75,761Net income per common share:Basic
    
    $
    1.34
    
    
    $
    2.89
    
    
    $
    5.47Diluted
    
    
    1.33
    
    
    
    2.60
    
    
    
    4.85
 See accompanying notes to consolidated financial statements. 6




---



##### 



Capstead Mortgage Corporation Consolidated Balance Sheets (In thousands, except per share amounts) December 312004
    
    
    2003AssetsMortgage securities and similar investments
($3.3 billion pledged under repurchase arrangements)
    
    $
    3,382,372
    
    
    $
    2,195,117CMO collateral
    
    
    56,187
    
    
    
    167,5713,438,559
    
    
    
    2,362,688Real estate held for lease, net of accumulated depreciation
    
    
    129,705
    
    
    
    133,414Receivables and other assets
    
    
    46,688
    
    
    
    41,880Cash and cash equivalents
    
    
    73,030
    
    
    
    16,340$
    3,687,982
    
    
    $
    2,554,322LiabilitiesRepurchase arrangements and similar borrowings
    
    $
    3,166,059
    
    
    $
    1,975,178Collateralized mortgage obligations (CMOs)
    
    
    55,735
    
    
    
    166,807Borrowings secured by real estate
    
    
    120,001
    
    
    
    120,206Common stock dividend payable
    
    
    4,151
    
    
    
    8,829Accounts payable and accrued expenses
    
    
    9,497
    
    
    
    6,2643,355,443
    
    
    
    2,277,284Stockholders equityPreferred stock  $0.10 par value; 100,000 shares authorized:$1.60 Cumulative Preferred Stock, Series A,
202 and 211 shares issued and outstanding at
December 31, 2004 and December 31, 2003, respectively
($3,317 aggregate liquidation preference)
    
    
    2,827
    
    
    
    2,956$1.26 Cumulative Convertible Preferred Stock, Series B,
15,819 shares issued and outstanding at
December 31, 2004 and December 31, 2003
($180,025 aggregate liquidation preference)
    
    
    176,705
    
    
    
    176,707Common stock  $0.01 par value; 100,000 shares authorized;
18,867 and 14,015 shares issued and outstanding at
December 31, 2004 and December 31, 2003, respectively
    
    
    189
    
    
    
    140Paid-in capital
    
    
    516,704
    
    
    
    456,198Accumulated deficit
    
    
    (387,718
    )
    
    
    (387,718
    )Accumulated other comprehensive income
    
    
    23,832
    
    
    
    28,755332,539
    
    
    
    277,038$
    3,687,982
    
    
    $
    2,554,322
 See accompanying notes to consolidated financial statements. 7




---



##### 



Capstead Mortgage Corporation Consolidated Statements of Stockholders equity (In thousands, except per share amounts) AccumulatedOther
    
    
    TotalPreferred
    
    
    Common
    
    
    Paid-in
    
    
    Accumulated
    
    
    Comprehensive
    
    
    StockholdersStock
    
    
    Stock
    
    
    Capital
    
    
    Deficit
    
    
    Income
    
    
    EquityBalance at January 1, 2002
    
    $
    180,782
    
    
    $
    139
    
    
    $
    559,571
    
    
    $
    (387,718
    )
    
    $
    51,954
    
    
    $
    404,728Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    96,123
    
    
    
    
    
    
    
    96,123Other comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (4,483
    )
    
    
    (4,483
    )Cash dividends:Common  regular
($5.56 per share)
    
    
    
    
    
    
    
    
    
    
    (1,607
    )
    
    
    (75,761
    )
    
    
    
    
    
    
    (77,368
    )Common  special
($7.19 per share)
    
    
    
    
    
    
    
    
    
    
    (100,389
    )
    
    
    
    
    
    
    
    
    
    
    (100,389
    )Preferred
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (20,362
    )
    
    
    
    
    
    
    (20,362
    )Conversion of preferred stock
    
    
    (1,016
    )
    
    
    1
    
    
    
    1,015
    
    
    
    
    
    
    
    
    
    
    
    Additions to capital
    
    
    
    
    
    
    
    
    
    
    329
    
    
    
    
    
    
    
    
    
    
    
    329Balance at December 31, 2002
    
    
    179,766
    
    
    
    140
    
    
    
    458,919
    
    
    
    (387,718
    )
    
    
    47,471
    
    
    
    298,578Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    60,659
    
    
    
    
    
    
    
    60,659Other comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (18,716
    )
    
    
    (18,716
    )Cash dividends:Common  regular
($3.10 per share)
    
    
    
    
    
    
    
    
    
    
    (3,018
    )
    
    
    (40,386
    )
    
    
    
    
    
    
    (43,404
    )Preferred
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (20,273
    )
    
    
    
    
    
    
    (20,273
    )Conversion of preferred stock
    
    
    (103
    )
    
    
    
    
    
    
    103
    
    
    
    
    
    
    
    
    
    
    
    Additions to capital
    
    
    
    
    
    
    
    
    
    
    194
    
    
    
    
    
    
    
    
    
    
    
    194Balance at December 31, 2003
    
    
    179,663
    
    
    
    140
    
    
    
    456,198
    
    
    
    (387,718
    )
    
    
    28,755
    
    
    
    277,038Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    41,805
    
    
    
    
    
    
    
    41,805Other comprehensive loss:Amounts related to cash flow
hedges, net
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (450
    )
    
    
    (450
    )Change in unrealized gain
on debt securities, net
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (4,473
    )
    
    
    (4,473
    )Comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    36,882Cash dividends:Common  regular
($1.58 per share)
    
    
    
    
    
    
    
    
    
    
    (4,219
    )
    
    
    (21,546
    )
    
    
    
    
    
    
    (25,765
    )Preferred
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (20,259
    )
    
    
    
    
    
    
    (20,259
    )Conversion of preferred stock
    
    
    (131
    )
    
    
    
    
    
    
    131
    
    
    
    
    
    
    
    
    
    
    
    Additions to capital
    
    
    
    
    
    
    49
    
    
    
    64,594
    
    
    
    
    
    
    
    
    
    
    
    64,643Balance at December 31, 2004
    
    $
    179,532
    
    
    $
    189
    
    
    $
    516,704
    
    
    $
    (387,718
    )
    
    $
    23,832
    
    
    $
    332,539
 See accompanying notes to consolidated financial statements. 8




---



##### 



Capstead Mortgage Corporation Consolidated Statements of Cash Flows (In thousands) Year Ended December 312004
    
    
    2003
    
    
    2002Operating activities:Net income
    
    $
    41,805
    
    
    $
    60,659
    
    
    $
    96,123Noncash items:Amortization of discount and premium
    
    
    14,961
    
    
    
    11,088
    
    
    
    22,936Depreciation and other amortization
    
    
    4,348
    
    
    
    4,868
    
    
    
    4,081Recognition of rent abatement
    
    
    170
    
    
    
    101
    
    
    
    (3,223
    )Gain on asset sales and CMO redemptions
    
    
    
    
    
    
    (4,560
    )
    
    
    (4,725
    )Change in incentive fee payable to former affiliate
    
    
    
    
    
    
    (4,982
    )
    
    
    (3,151
    )Net change in receivables, other assets, accounts payable and
accrued expenses
    
    
    4,500
    
    
    
    15,865
    
    
    
    1,429Net cash provided by operating activities
    
    
    65,784
    
    
    
    83,039
    
    
    
    113,470Investing activities:Purchases of mortgage securities and similar investments
    
    
    (2,095,002
    )
    
    
    (518,090
    )
    
    
    (184,176
    )Purchase of real estate
    
    
    
    
    
    
    
    
    
    
    (18,828
    )Principal collections on mortgage securities and
similar investments
    
    
    880,676
    
    
    
    870,583
    
    
    
    1,134,295Proceeds from asset sales
    
    
    
    
    
    
    125,020
    
    
    
    97,003CMO collateral:Principal collections
    
    
    109,649
    
    
    
    641,041
    
    
    
    1,131,708Decrease in accrued interest receivable
    
    
    695
    
    
    
    3,647
    
    
    
    7,028Net cash (used in) provided by investing activities
    
    
    (1,103,982
    )
    
    
    1,122,201
    
    
    
    2,167,030Financing activities:Net increase (decrease) in repurchase arrangements and
similar borrowings
    
    
    1,190,881
    
    
    
    (170,478
    )
    
    
    (1,061,412
    )Increase (decrease) in borrowings secured by real estate:Issuance of borrowings
    
    
    
    
    
    
    
    
    
    
    100,841Principal payments on borrowings
    
    
    (205
    )
    
    
    (194
    )
    
    
    (101,278
    )CMO borrowings:Principal payments on securities
    
    
    (108,961
    )
    
    
    (901,018
    )
    
    
    (1,168,682
    )Decrease in accrued interest payable
    
    
    (646
    )
    
    
    (4,847
    )
    
    
    (6,468
    )Capital stock transactions
    
    
    64,521
    
    
    
    67
    
    
    
    189Dividends paid
    
    
    (50,702
    )
    
    
    (171,433
    )
    
    
    (102,327
    )Net cash (used in) provided by financing activities
    
    
    1,094,888
    
    
    
    (1,247,903
    )
    
    
    (2,339,137
    )Net change in cash and cash equivalents
    
    
    56,690
    
    
    
    (42,663
    )
    
    
    (58,637
    )Cash and cash equivalents at beginning of year
    
    
    16,340
    
    
    
    59,003
    
    
    
    117,640Cash and cash equivalents at end of year
    
    $
    73,030
    
    
    $
    16,340
    
    
    $
    59,003
 See accompanying notes to consolidated financial statements. 9




---



##### 



Capstead Mortgage Corporation Notes to Consolidated Financial Statements December 31, 2004 NOTE 1 3⁄4 BUSINESS Capstead Mortgage Corporation (together with its subsidiaries, 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
primarily consist of, but are not limited to, residential financial assets, specifically
adjustable-rate mortgage (ARM) securities issued and guaranteed by government-sponsored entities,
either Fannie Mae or Freddie Mac, or by an agency of the federal government, Ginnie Mae
(collectively, Agency Securities). Capstead has also made limited investments in
credit-sensitive commercial real estate-related assets, including the direct ownership of real
estate. Management believes such investments, when available at favorable prices and combined with
the prudent use of leverage, can produce attractive risk-adjusted returns over the long term with
relatively low sensitivity to changes in interest rates. The earning capacity of Capsteads financial asset portfolios is influenced by the overall
size and composition of the portfolios, which depends on investment strategies being implemented by
management, the availability of attractively-priced investments and overall market conditions.
Market conditions are influenced by, among other things, current levels of, and expectations for
future levels of, 30-day to two-year interest rates and mortgage prepayments. Financing spreads
(the difference between yields earned on these investments and interest rates charged on related
borrowings) have declined from the historically wide levels achieved the last several years when
short-term interest rates were lower and are expected to continue declining into 2005 before
beginning to recover late in the year. Because the majority of the Companys financial assets
currently consist of ARM securities backed by mortgage loans with coupon interest rates that reset
at least annually, management believes the Company is well positioned to manage through the higher
interest rate environment currently anticipated for 2005, albeit at a lower earnings level than
that achieved the last several years when short-term interest rates were lower. NOTE 2 3⁄4 ACCOUNTING POLICIES Principles of Consolidation The consolidated financial statements include the accounts of Capstead Mortgage Corporation
and its subsidiaries, including certain finance and real estate subsidiaries. Intercompany
balances and transactions have been eliminated. Substantially all of the assets of the finance
subsidiaries are pledged to secure collateralized mortgage obligations (CMOs) and are not
available for the satisfaction of general claims of Capstead. Similarly, real estate held for
lease and related assets are owned by real estate subsidiaries and pledged to secure related
borrowings. Capstead has no responsibility for CMOs or borrowings secured by real estate beyond
the assets pledged as collateral. 10




---



##### 



Capstead Mortgage Corporation 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 earnings. Similarly, depreciation on real estate is based on estimates of the useful lives
of buildings, equipment and fixtures, which could be affected by significant adverse events or
changes in circumstances and potentially lead to impairment charges. 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 and are influenced by changes in, and market expectations for changes in, interest rates and
levels of mortgage prepayments as well as other factors beyond the control of management.
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 incomein stockholders equity and the
calculation of incentive fees. Reclassifications Certain prior year amounts have been reclassified to conform to the current year presentation. Financial Assets Financial assets held in the form of asset-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 may be classified as held-to-maturity
when the Company has the 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 and losses reported as a separate component of Accumulated other comprehensive
incomein stockholders equity. Financial assets held in the form of whole loans are carried at
their unpaid principal balances, net of unamortized discount or premium. The Company may from time
to time hold loans for sale. Such loans are carried at the lower of cost or market on an aggregate
basis. Transfers from loans for sale to loans for investment are recorded at the lower of cost or
market. Interest is recorded as income when earned. Premiums and discounts are recognized as adjustments
to Interest incomeby the interest method over the expected life of the related financial asset.
Realized gains and losses are included in Other revenue (expense). The cost of financial assets
sold is based on the specific identification method. Unrealized gains and losses are not amortized
to income; however, if a decline in fair value of an individual financial 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 11




---



##### 



Capstead Mortgage Corporation (expense)as an impairment charge. No impairment charges on financial assets have been recorded
during the three years ended December 31, 2004. Real Estate Held for Lease Land, buildings, equipment and fixtures are carried at cost, less accumulated depreciation.
Depreciation is provided using the straight-line method over the estimated useful lives of the
depreciable assets (40 years for buildings and five years for equipment and fixtures). Should a
significant adverse event or change in circumstances occur, the values of the affected real estate
properties will be assessed for impairment. A property is considered impaired only if estimated
operating cash flows (undiscounted and without interest charges) over its remaining useful life are
less than net carrying value. If impaired, the difference between net carrying value and fair
value would be included in Other revenue (expense)as an impairment charge. No impairment charges
on real estate assets have been recorded during the three years ended December 31, 2004. Real Estate Lease Income Recognition Base rents are recognized on a straight-line basis over the term of the related leases. Base
rent escalations, when present, are recognized when earned if dependent upon unknown factors such
as future increases in the Core Consumer Price Index. Cash and Cash Equivalents Cash and cash equivalents include unrestricted 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 financial assets or various other Derivatives
available in the marketplace that are compatible with the Companys risk management objectives.
Derivatives held are recorded as assets or liabilities at fair value on the Companys balance
sheet. The accounting for changes in fair value of each Derivative held depends on whether it has
been designated and qualifies as an accounting hedge, as well as the type of hedging relationship
identified. Capstead has made limited use of Derivatives during the three years ended December 31, 2004.
Included in Receivables and other assetsare interest rate caps acquired in connection with the
2002 assumption and subsequent refinancing of tax-exempt bonds secured by Real estate held for
lease(see NOTE 9), which are designated as an accounting hedge with changes in value considered
100% correlated to changes in expected future cash flows of the variable-rate bonds, excluding the
effects of time value. Accordingly, changes in time value are amortized to Interest expenseas a
yield adjustment and other changes in value are recorded in Accumulated other comprehensive income.
Until exercised, call rights on certain securitizations issued by the Company and accounted for as
sales were recognized as cash flow hedges on the purchase of a modest amount of ARM securities at
par value. The fair value of these call rights was based on the discounted fair value of the
related ARM securities in excess of par, less transaction costs. As such, changes in the value of
the call 12




---



##### 



Capstead Mortgage Corporation rights prior to exercise were 100% correlated to changes in value of the ARM securities, excluding
the effects of time value, which were recorded in Other revenue (expense). Upon exercise, the ARM
securities were recorded at par and the values assigned to the related call rights were
reclassified as investment premiums and are being amortized to Interest incomeas yield
adjustments. Related amounts recorded in Accumulated other comprehensive incomeare being
amortized to Interest incomeconcurrently. Borrowings Repurchase arrangements and other borrowings, including CMOs and borrowings secured by real
estate, are carried at their unpaid principal balances, net of unamortized discounts and premiums.
Discounts and premiums, as well as debt issue costs, which are recorded in Receivables and other
assets, are recognized as adjustments to Interest and related expenseby the interest method over
the expected term of the related borrowings. Income Taxes Capstead and its qualified REIT subsidiaries (Capstead REIT) have elected to be taxed as a
REIT. As a result of this election, Capstead REIT 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
of 1986 (the Code), which may extend into the subsequent taxable year. Capstead may find it
advantageous from time to time to elect taxable REIT subsidiary status for certain of its qualified
REIT subsidiaries. All taxable income, if any, of Capsteads taxable REIT subsidiaries is subject
to federal and state income taxes, where applicable. Income taxes are accounted for using the liability method. 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. Incentive Fees Management and employees participate in an incentive compensation program established by the
Board of Directors. Until July 22, 2003, management included an affiliate of Fortress Investment
Group LLC. Fortress Investment Group LLC, together with its affiliates, is referred to as
Fortress. Fortress was the Companys controlling stockholder, and its chairman of the board was
also Capsteads Chairman of the Board and Chief Executive Officer (see NOTE 14). 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 as those terms are defined by the program. Modified total return is measured as the change
in modified common book value per share during the year, together with common dividends per share
and excludes the effects of raising equity capital. Modified common book value is determined by
deducting from total equity the recorded value of preferred equity and unrealized gains and losses
on investments not included in Accumulated other comprehensive incomeand adding back incentive fee
accruals. Incentive fee amounts were also awarded in 2004 relative to raising equity capital. 13




---



##### 



Capstead Mortgage Corporation Stock-Based Compensation As more fully described in NOTE 13, Capstead accounts for stock-based awards for employees and
directors under the recognition and measurement principles of the Accounting Principles Board
Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations (APB25).
Under APB25 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 grant over the
amount to be paid to acquire the stock and is recognized in Other operating expenseas the awards
vest and restrictions lapse on a straight-line basis. If the Company had expensed stock-based
compensation costs determined using the fair value-based methodology prescribed by Statement of
Financial Accounting Standards No. 123 Accounting for Stock-based Compensation (SFAS 123), such
expense would have been higher by $41,000, $35,000 and $84,000 in 2004, 2003 and 2002,
respectively, which would have had no effect on reported diluted net income per common share in any
of the years presented. In December 2004 the Financial Accounting Standards Board revised SFAS 123 to supercede APB25
and require the use of a fair value-based methodology (similar to the original SFAS 123
methodology) to measure and record liabilities associated with stock-based compensation. The
revised standard is required to be adopted by Capstead beginning July 1, 2005 and is applicable to
any new awards and to all existing awards for which the requisite service to earn the award has not
yet been rendered. The effect on Capsteads earnings and financial condition of adopting the
revised standard cannot be predicted at this time because it depends on levels of stock-based
awards that may be issued in future periods. Net Income per Common Share Basic net income per common share is computed by dividing net income, after deducting
preferred share dividends, by the weighted average number of common shares outstanding. Diluted
net income per common share is computed by dividing net income, 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. NOTE 3 3⁄4 CALCULATION OF NET INCOME
PER COMMON SHARE The components of the computation of basic and diluted net income per common share were
as follows (in thousands, except per share amounts): Year Ended December 312004
    
    
    2003
    
    
    2002Numerator for basic net income per common share:Net income
    
    $
    41,805
    
    
    $
    60,659
    
    
    $
    96,123Less preferred share dividends
    
    
    (20,259
    )
    
    
    (20,273
    )
    
    
    (20,362
    )$
    21,546
    
    
    $
    40,386
    
    
    $
    75,761Denominator for basic net income per common share:Weighted average common shares outstanding
    
    
    16,100
    
    
    
    13,977
    
    
    
    13,858Basic net income per common share
    
    $
    1.34
    
    
    $
    2.89
    
    
    $
    5.47
 14




---



##### 



Capstead Mortgage Corporation Year Ended December 312004
    
    
    2003
    
    
    2002Numerator for diluted net income per common share:Net income
    
    $
    41,805
    
    
    $
    60,659
    
    
    $
    96,123Less dividends on antidilutive convertible preferred shares
    
    
    (19,932
    )
    
    
    
    
    
    
    $
    21,873
    
    
    $
    60,659
    
    
    $
    96,123Denominator for diluted net income per common share:Weighted average common shares outstanding
    
    
    16,100
    
    
    
    13,977
    
    
    
    13,858Net effect of dilutive stock options
    
    
    29
    
    
    
    35
    
    
    
    57Net effect of dilutive convertible preferred shares:Series A
    
    
    308
    
    
    
    315
    
    
    
    260Series B
    
    
    
    
    
    
    8,968
    
    
    
    5,65216,437
    
    
    
    23,295
    
    
    
    19,827Diluted net income per common share
    
    $
    1.33
    
    
    $
    2.60
    
    
    $
    4.85
 For dilutive net income per common share purposes, the Series A and B preferred shares are
considered dilutive whenever annualized basic net income per common share exceeds each Series
annualized dividend divided by the conversion rate applicable for that period. NOTE 4 3⁄4 MORTGAGE SECURITIES AND SIMILAR INVESTMENTS The Company classifies its investments in mortgage securities and similar financial
assets by collateral type and interest rate characteristics. Agency Securities are AAA-rated and
are considered to have limited credit risk. Non-agency securities consist of private mortgage
pass-through securities originally formed prior to 1995 when the Company operated a mortgage
conduit. These securities are backed by residential mortgage loans whereby the related credit risk
of the underlying loans is either borne by AAA-rated private mortgage insurers or by the Company
(Non-agency Securities). Included in Receivables and other assetsas restricted cash at December
31, 2004 was $6.0 million in related reserve funds for special hazards (e.g. earthquake or
mudslide-related losses) and certain bankruptcy losses. 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. Commercial mortgage-backed securities
(CMBS) held by the Company as of December 31, 2004 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 securities is directly
affected by the rate of principal prepayments on the underlying loans. Fixed-rate investments generally are mortgage securities backed by mortgage loans that have fixed
rates of interest over the life of the loans. Adjustable-rate investments generally are mortgage
securities backed by mortgage loans that have interest rates that adjust at least annually to more
current interest rates (current-reset ARM securities) or begin doing so after an initial
fixed-rate period (longer-to-reset ARM securities). Mortgage loans underlying current-reset ARM
securities either (i) adjust annually based on a specified margin over the one-year Constant
Maturity U.S. Treasury Note Rate or the one-year London Interbank Offered Rate (LIBOR), (ii)
adjust semiannually based on a specified margin over six-month LIBOR, or (iii) adjust monthly based
on a specific margin over an index 15




---



##### 



Capstead Mortgage Corporation such as LIBOR or the Eleventh District Federal Reserve Bank Cost of Funds Index, usually subject to
periodic and lifetime limits on the amount of such adjustments during any single interest rate
adjustment period and over the life of the loan. Mortgage loans underlying longer-to-reset ARM
securities have initial fixed rates of interest of three to ten years before beginning to adjust in
rate as described above. The average period until initial reset for the $629 million in
longer-to-reset ARM securities held by the Company as of December 31, 2004 was 25 months compared
to less than 6 months to the next reset date for the Companys current-reset ARM securities. CMBS
held as of December 31, 2004 adjust monthly based on a specified margin over 30-day LIBOR.
Mortgage securities and similar investmentsand related weighted average rates were as follows
(dollars in thousands): Average
    
    
    AveragePrincipal
    
    
    Premiums
    
    
    
    
    
    
    Carrying
    
    
    Coupon
    
    
    EffectiveBalance
    
    
    (Discounts)
    
    
    Basis
    
    
    Amount(a)
    
    
    Rate(b)
    
    
    Rate(b)December 31, 2004Agency Securities:Fannie Mae/Freddie Mac:Fixed-rate
    
    $
    35,538
    
    
    $
    146
    
    
    $
    35,684
    
    
    $
    35,739
    
    
    
    6.63
    %
    
    
    6.13
    %ARMs
    
    
    2,116,454
    
    
    
    39,572
    
    
    
    2,156,026
    
    
    
    2,170,766
    
    
    
    3.96
    
    
    
    3.01Ginnie Mae ARMs
    
    
    1,017,517
    
    
    
    7,583
    
    
    
    1,025,100
    
    
    
    1,033,506
    
    
    
    3.87
    
    
    
    3.153,169,509
    
    
    
    47,301
    
    
    
    3,216,810
    
    
    
    3,240,011
    
    
    
    3.96
    
    
    
    3.10Non-agency Securities:Fixed-rate
    
    
    34,338
    
    
    
    24
    
    
    
    34,362
    
    
    
    34,415
    
    
    
    6.78
    
    
    
    6.20ARMs
    
    
    55,615
    
    
    
    646
    
    
    
    56,261
    
    
    
    56,739
    
    
    
    4.12
    
    
    
    3.2489,953
    
    
    
    670
    
    
    
    90,623
    
    
    
    91,154
    
    
    
    5.14
    
    
    
    4.61CMBS
    
    
    51,159
    
    
    
    10
    
    
    
    51,169
    
    
    
    51,207
    
    
    
    3.44
    
    
    
    2.47$
    3,310,621
    
    
    $
    47,981
    
    
    $
    3,358,602
    
    
    $
    3,382,372
    
    
    
    3.98
    
    
    
    3.16December 31, 2003Agency Securities:Fannie Mae/Freddie Mac:Fixed-rate
    
    $
    2,072
    
    
    $
    12
    
    
    $
    2,084
    
    
    $
    2,160
    
    
    
    10.00
    %
    
    
    9.38
    %ARMs
    
    
    1,141,430
    
    
    
    13,003
    
    
    
    1,154,433
    
    
    
    1,176,058
    
    
    
    3.66
    
    
    
    3.70Ginnie Mae ARMs
    
    
    726,876
    
    
    
    7,830
    
    
    
    734,706
    
    
    
    739,987
    
    
    
    4.27
    
    
    
    4.101,870,378
    
    
    
    20,845
    
    
    
    1,891,223
    
    
    
    1,918,205
    
    
    
    3.90
    
    
    
    3.88Non-agency Securities:Fixed-rate
    
    
    118,638
    
    
    
    174
    
    
    
    118,812
    
    
    
    118,812
    
    
    
    6.66
    
    
    
    6.25ARMs
    
    
    81,425
    
    
    
    1,293
    
    
    
    82,718
    
    
    
    83,724
    
    
    
    4.42
    
    
    
    3.64200,063
    
    
    
    1,467
    
    
    
    201,530
    
    
    
    202,536
    
    
    
    5.75
    
    
    
    4.63CMBS and commercial loans
    
    
    74,376
    
    
    
    (9
    )
    
    
    74,367
    
    
    
    74,376
    
    
    
    2.21
    
    
    
    4.44$
    2,144,817
    
    
    $
    22,303
    
    
    $
    2,167,120
    
    
    $
    2,195,117
    
    
    
    4.02
    
    
    
    3.97
   (a)
    Includes mark-to-market for securities classified as available-for-sale, if applicable
(see NOTE 10).(b)
    Average Coupon Rate is presented net of servicing and other fees as of the indicated balance
sheet date. Average Effective Rate is presented for the year then ended, calculated
including the amortization of premiums (discounts), mortgage insurance costs on Non-agency
Securities and excluding unrealized gains and losses. 16




---



##### 



Capstead Mortgage Corporation   NOTE 5 3⁄4 CMO COLLATERAL Collateral pledged to secure CMOs consists of Non-Agency Securities and related accrual
interest and short-term investments. The components of CMO collateralwere as follows (in
thousands): December 312004
    
    
    2003Non-Agency Securities
    
    $
    54,996
    
    
    $
    164,891Accrued interest receivable
    
    
    390
    
    
    
    1,08555,386
    
    
    
    165,976Unamortized premium
    
    
    801
    
    
    
    1,595$
    56,187
    
    
    $
    167,571
 Credit risk associated with this collateral is borne by AAA-rated private mortgage insurers or
subordinated bonds within the related CMO series to which the collateral is pledged, none of which
were retained by the Company. Related weighted average effective interest rates were 6.44% and
6.20% during 2004 and 2003, respectively. NOTE 6 3⁄4 REAL ESTATE HELD FOR LEASE In May 2002 Capstead acquired six independent senior living facilities wherein the
operator of the facility provides tenants little, if any, medical care (collectively, the
Properties). The aggregate purchase price of the Properties was $139.7 million including
approximately $3.1 million in closing costs and the assumption by Capstead of $19.7 million of
related mortgage debt and $101.1 million of tax-exempt bond debt. The Properties were acquired pursuant to purchase agreements initially negotiated and executed
by an affiliate of Brookdale Living Communities, Inc. (collectively with its subsidiaries,
Brookdale) and subsequently assigned to Capstead. Concurrent with the acquisition, the Company
entered into a long-term net-lease arrangement with Brookdale, under which Brookdale is
responsible for the ongoing operation and management of the Properties. Brookdale, an owner,
operator, developer and manager of senior living facilities, is a majority-owned affiliate of
Fortress. The lease arrangement consists of a master lease covering all of the Properties and individual
property-level leases (referred to collectively as the Lease). The Lease has an initial term of
20 years and provides for two 10-year renewal periods. Beginning May 1, 2007, Brookdale will have
the option of purchasing all of the Properties from Capstead at the greater of fair value or
Capsteads original cost, after certain adjustments. Brookdale is responsible for paying all
expenses associated with the operation of the Properties, including real estate taxes, other
governmental charges, insurance, utilities and maintenance, and an amount representing an
attractive cash return on Capsteads equity in the Properties after payment of monthly debt
service, subject to annual increases based upon increases (capped at 3%) in the Core Consumer Price
Index. Brookdale is responsible for changes in related debt service requirements under the terms
of the Lease; therefore, earnings from this investment are generally not affected by changes in
interest rates. Included in Receivables and other assetsat December 31, 2004 was $3.0 million in
unamortized rent 17




---



##### 



Capstead Mortgage Corporation abatements and $1.2 million of rent and other receivables due from Brookdale. Carrying amounts of
the Properties were as follows (in thousands): December 312004
    
    
    2003Land
    
    $
    16,450
    
    
    $
    16,450Buildings
    
    
    119,550
    
    
    
    119,550Equipment and fixtures
    
    
    3,600
    
    
    
    3,600139,600
    
    
    
    139,600Accumulated depreciation
    
    
    (9,895
    )
    
    
    (6,186
    )$
    129,705
    
    
    $
    133,414
 NOTE 7 3⁄4 REPURCHASE ARRANGEMENTS
AND SIMILAR BORROWINGS Capstead borrows under uncommitted repurchase arrangements with well-established
investment banking firms. Repurchase arrangements pursuant to which the Company pledges mortgage
securities as collateral generally have maturities of less than 31 days, although during 2004 the
Company extended maturities for up to two years on a portion of its borrowings primarily related to
the Companys modest position in fixed-rate and longer-to-reset ARM securities. From time to time
the Company may obtain similar borrowings from other parties such as commercial banks to finance
investments in financial assets that are not mortgage-backed securities. The terms and conditions
of repurchase arrangements and any similar borrowings are negotiated on a
transaction-by-transaction basis. These borrowings consisted solely of repurchase arrangements as
of December 31, 2004 and 2003. Related weighted average interest rates, classified by type of
collateral and maturities, were as follows for the dates indicated (dollars in thousands): December 31, 2004
    
    
    December 31, 2003Borrowings
    
    
    Average
    
    
    Borrowings
    
    
    AverageOutstanding
    
    
    Rate
    
    
    Outstanding
    
    
    RateAgency Securities (less than 31 days)
    
    $
    2,340,755
    
    
    
    2.28
    %
    
    $
    1,735,027
    
    
    
    1.09
    %Agency Securities (31 to 90 days)
    
    
    54,021
    
    
    
    1.98
    
    
    
    
    
    
    
    Agency Securities (91 to 360 days)
    

    
    204,983
    
    
    
    2.19
    
    
    
    
    
    
    
    Agency Securities (greater than 360 days)
    
    
    446,744
    
    
    
    2.61
    
    
    
    
    
    
    
    Non-agency Securities (less than 31 days)
    
    
    71,140
    
    
    
    2.76
    
    
    
    170,205
    
    
    
    1.57CMBS (less than 31 days)
    
    
    48,416
    
    
    
    2.54
    
    
    
    20,300
    
    
    
    1.36CMBS (greater than 90 days)
    
    
    
    
    
    
    
    
    
    
    49,646
    
    
    
    1.34$
    3,166,059
    
    
    
    2.33
    
    
    $
    1,975,178
    
    
    
    1.14
 As of December 31, 2004, Capstead had $43 million of its capital at risk with its largest
single counter-party (Cantor Fitzgerald Securities), related to $806 million in repurchase
arrangements that had an average maturity of eleven months. Weighted average effective interest
rates on Repurchase arrangements and similar borrowingswere 1.54% and 1.23% during 2004 and 2003,
respectively. Related interest paid totaled $34.3 million, $24.7 million and $50.0 million during
2004, 2003, and 2002, respectively. 18




---



##### 



Capstead Mortgage Corporation NOTE 8 3⁄4 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 at specified rates for all classes. The components
of CMOs, along with selected other information, were as follows for the dates indicated (dollars in
thousands): December 312004
    
    
    2003CMOs
    
    $
    54,739
    
    
    $
    164,388Accrued interest payable
    
    
    292
    
    
    
    938Total obligation
    
    
    55,031
    
    
    
    165,326Unamortized premium
    
    
    704
    
    
    
    1,481$
    55,735
    
    
    $
    166,807Range of average interest rates
    
    2.29% to 9.60%
    
    1.50% to 9.42%Range of stated maturities
    
    
    2025 to 2030
    
    
    
    2025 to 2030Number of series
    
    
    5
    
    
    
    6
 Typically, principal payments on each series are made to each class in the order of their
stated maturities so that no payment of principal is made on any class of bonds until all classes
having an earlier stated maturity have been paid in full. The maturity of each CMO series is
directly affected by the rate of principal prepayments on the related CMO collateral. Each series
is also subject to redemption provided 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. Weighted average effective interest rates for CMO borrowingswere 5.73% and 6.12% during 2004
and 2003, respectively. Related interest paid totaled $8.1 million, $40.3 million and $117.6
million during 2004, 2003 and 2002, respectively. NOTE 9 3⁄4 BORROWINGS SECURED BY REAL ESTATE The components of Borrowings secured by real estateand related weighted average interest
rates (calculated including bond issue cost amortization) were as follows for the dates indicated
(dollars in thousands): December 31, 2004
    
    
    December 31, 2003Borrowings
    
    
    Average
    
    
    Borrowings
    
    
    AverageOutstanding
    
    
    Rate
    
    
    Outstanding
    
    
    RateMortgage borrowings
    
    $
    19,160
    
    
    
    7.92
    %
    
    $
    19,365
    
    
    
    7.92
    %Tax-exempt bonds
    
    
    100,841
    
    
    
    2.98
    
    
    
    100,841
    
    
    
    2.54$
    120,001
    
    
    
    3.77
    
    
    $
    120,206
    
    
    
    3.40
 Mortgage borrowings consist of a fixed-rate mortgage secured by one senior living facility that
matures in 2009. The tax-exempt bonds are credit-enhanced by Fannie Mae and secured by mortgages
on the remaining five senior living facilities. Interest rates on the bonds adjust weekly based on
the Bond Market Association Municipal Swap Index (BMA Index). Interest rate cap agreements with
notional amounts aggregating $100.8 million, 19




---



##### 



Capstead Mortgage Corporation five-year terms, and cap rates equal to a 6% BMA Index, are held to provide funds to pay interest
on the bonds in excess of a 6% BMA Index, should that occur. Monthly interest rate cap and
principal reserve fund payments are made to the trustee for the purchase of new cap agreements in
2007 and the eventual retirement of the bonds by 2032. Held in escrow by the bond trustee as of
December 31, 2004 were a total of $4.1 million in interest rate cap reserves, principal reserves
and repair and replacement reserves. These funds are included in Receivables and other assetsas
restricted cash. Also included in Receivables and other assetsare $2.9 million in bond issue
costs. Weighted average effective interest rates for Borrowings secured by real estate(calculated
including bond issue cost amortization) were 3.71% and 3.59% during 2004 and 2003, respectively.
Related interest paid totaled $4.5 million, $4.3 million and $4.8 million during 2004, 2003 and
2002, respectively. As of December 31, 2004 future maturities and principal reserve fund
requirements for these borrowings were as follows (in thousands): 2005
    
    $
    1,5132006
    
    
    1,6172007
    
    
    1,7302008
    
    
    1,8502009
    
    
    1,978Thereafter
    
    
    108,877$
    117,565
 NOTE 10 3⁄4 DISCLOSURES REGARDING FAIR VALUES
OF FINANCIAL INSTRUMENTS The carrying amounts of cash and cash equivalents, restricted cash, receivables, payables
and repurchase arrangements approximate fair value. Fair values of Derivatives, Agency Securities,
Non-agency Securities, CMBS and Borrowings secured by real estatewere 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. Fair values of CMO collateralwere based on projected cash flows, after payment
on the related CMOs, determined using market discount rates and prepayment assumptions. Fair
values of CMOs were based on the same method for determining fair value of CMO collateraladjusted
for credit enhancements. The maturity of mortgage assets is directly affected by the rate of
principal payments on the underlying mortgage loans and, for CMO collateral, Clean-up Calls of the
remaining CMOs outstanding. Fair values of the Companys investments are influenced by changes in, and market expectations
for changes in, interest rates and levels of mortgage prepayments as well as other factors beyond
the control of management. Fluctuations in fair value caused by changes in interest rates are
generally offset in a relatively short period of time because most of the Companys investments
adjust to more current rates at least annually. As of December 31, 2004, $885 million of the
Companys investments in mortgage securities carried unrealized losses totaling $3.5 million. Only
$145 million of these securities were carried at a loss at December 31, 2003. Given that managing
a large portfolio of mortgage securities remains the core focus of Capsteads investment strategy,
it is likely that these securities will be held to maturity. Consequently, temporary declines in
value because of increases in interest rates would not constitute other-than-temporary impairments
in value necessitating writedowns, absent a major shift in the Companys investment focus. 20




---



##### 



Capstead Mortgage Corporation Fair value disclosures for financial instruments were as follows (in thousands): December 31, 2004
    
    
    December 31, 2003Carrying
    
    
    Fair
    
    
    Carrying
    
    
    FairAmount
    
    
    Value
    
    
    Amount
    
    
    ValueAssets:Cash and cash equivalents
    
    $
    73,030
    
    
    $
    73,030
    
    
    $
    16,340
    
    
    $
    16,340Restricted cash
    
    
    10,151
    
    
    
    10,151
    
    
    
    14,789
    
    
    
    14,789Receivables
    
    
    28,752
    
    
    
    28,752
    
    
    
    18,214
    
    
    
    18,214Derivatives (interest rate caps)
    
    
    26
    
    
    
    26
    
    
    
    317
    
    
    
    317Mortgage securities and similar
investments
    
    
    3,382,372
    
    
    
    3,385,343
    
    
    
    2,195,117
    
    
    
    2,199,310CMO collateral
    
    
    56,187
    
    
    
    57,415
    
    
    
    167,571
    
    
    
    172,053Liabilities:Payables
    
    
    13,648
    
    
    
    13,648
    
    
    
    15,093
    
    
    
    15,093Repurchase arrangements and similar
borrowings
    
    
    3,166,059
    
    
    
    3,161,719
    
    
    
    1,975,178
    
    
    
    1,975,178CMOs
    
    
    55,735
    
    
    
    56,879
    
    
    
    166,807
    
    
    
    171,065Borrowings secured by real estate
    
    
    120,001
    
    
    
    120,936
    
    
    
    120,206
    
    
    
    120,556
 Fair value disclosures for available-for-sale debt securities were as follows (in thousands): Gross
    
    
    GrossCost
    
    
    Unrealized
    
    
    Unrealized
    
    
    FairBasis
    
    
    Gains
    
    
    Losses
    
    
    ValueAs of December 31, 2004Agency Securities:Fixed-rate
    
    $
    606
    
    
    $
    55
    
    
    $
    
    
    
    $
    661ARMs
    
    
    3,181,126
    
    
    
    26,467
    
    
    
    3,321
    
    
    
    3,204,2723,181,732
    
    
    
    26,522
    
    
    
    3,321
    
    
    
    3,204,933Non-Agency Securities
    
    
    41,166
    
    
    
    564
    
    
    
    33
    
    
    
    41,697CMBS
    
    
    51,169
    
    
    
    39
    
    
    
    1
    
    
    
    51,207CMO collateral
    
    
    12,214
    
    
    
    253
    
    
    
    
    
    
    
    12,467$
    3,286,281
    
    
    $
    27,378
    
    
    $
    3,355
    
    
    $
    3,310,304As of December 31, 2003Agency Securities:Fixed-rate
    
    $
    827
    
    
    $
    76
    
    
    $
    
    
    
    $
    903ARMs
    
    
    1,889,139
    
    
    
    27,159
    
    
    
    253
    
    
    
    1,916,0451,889,966
    
    
    
    27,235
    
    
    
    253
    
    
    
    1,916,948Non-agency Securities
    
    
    58,613
    
    
    
    1,009
    
    
    
    3
    
    
    
    59,619CMBS
    
    
    74,367
    
    
    
    24
    
    
    
    15
    
    
    
    74,376CMO collateral
    
    
    16,440
    
    
    
    499
    
    
    
    
    
    
    
    16,939$
    2,039,386
    
    
    $
    28,767
    
    
    $
    271
    
    
    $
    2,067,882
 21




---



##### 



Capstead Mortgage Corporation Held-to-maturity debt securities consist of CMO collateraland collateral released from the
related CMO indentures pursuant to Clean-up Calls and held as Agency or Non-agency Securities.
Fair value disclosures for debt securities held-to-maturity were as follows (in thousands): Gross
    
    
    GrossCost
    
    
    Unrealized
    
    
    Unrealized
    
    
    FairBasis
    
    
    Gains
    
    
    Losses
    
    
    ValueAs of December 31, 2004Released CMO collateral:Agency Securities
    
    $
    35,078
    
    
    $
    1,723
    
    
    $
    
    
    
    $
    36,801Non-agency Securities
    
    
    49,457
    
    
    
    1,345
    
    
    
    97
    
    
    
    50,705CMO Collateral
    
    
    43,720
    
    
    
    84
    
    
    
    
    
    
    
    43,804$
    128,255
    
    
    $
    3,152
    
    
    $
    97
    
    
    $
    131,310As of December 31, 2003Released CMO Collateral:Agency Securities
    
    $
    1,257
    
    
    $
    113
    
    
    $
    
    
    
    $
    1,370Non-agency Securities
    
    
    142,917
    
    
    
    4,445
    
    
    
    365
    
    
    
    146,997CMO Collateral
    
    
    150,632
    
    
    
    224
    
    
    
    
    
    
    
    150,856$
    294,806
    
    
    $
    4,782
    
    
    $
    365
    
    
    $
    299,223
 Sales of debt securities were as follows (in thousands): Year Ended December 312004
    
    
    2003
    
    
    2002Sale of debt securities held available-for-sale:Amortized cost
    
    $
    
    
    
    $
    63,053
    
    
    $
    42,729Gain
    
    
    
    
    
    
    2,026
    
    
    
    1,602Sale of released CMO collateral held-to-maturity (a):Amortized cost
    
    
    
    
    
    
    58,014
    
    
    
    32,265Gain
    
    
    
    
    
    
    1,927
    
    
    
    1,222
   (a)
    Sales of released CMO collateral occasionally occur, provided the collateral has paid down
to within 10% of its original issuance amounts. NOTE 11 3⁄4 INCOME TAXES Capstead REIT files a separate federal income tax return that does not include the
operations of the Companys taxable REIT subsidiaries. Provided Capstead REIT remains qualified as
a REIT and all its taxable income is distributed to stockholders within time limits prescribed by
the Code, no income taxes are due on this income. Accordingly, no provision has been made for
income taxes for Capstead REIT. Taxable income, if any, of Capsteads taxable REIT subsidiaries is
fully taxable and provision is made for income taxes for these subsidiaries as necessary. The
Companys taxable REIT subsidiaries paid alternative minimum taxes of $14,000 and $81,000 during
2004 and 2002, respectively. 22




---



##### 



Capstead Mortgage Corporation Capsteads effective tax rate differs substantially from statutory federal income tax rates
primarily due to the benefit of Capstead REITs status as a REIT, as illustrated below, along with
other items affecting the Companys effective tax rate (in thousands): Year Ended December 312004
    
    
    2003
    
    
    2002Income taxes computed at the federal statutory rate
    
    $
    14,632
    
    
    $
    21,230
    
    
    $
    33,643Capital gain generated by Capstead REIT
    
    
    
    
    
    
    (946
    )
    
    
    (1,093
    )Benefit of REIT status
    
    
    (14,526
    )
    
    
    (19,203
    )
    
    
    (31,205
    )Income taxes computed on income of taxable
REIT subsidiaries
    
    
    106
    
    
    
    1,081
    
    
    
    1,345Change in net deferred income tax assets
    
    
    (20
    )
    
    
    (1,336
    )
    
    
    (1,785
    )Other
    
    
    (84
    )
    
    
    267
    
    
    
    521Income tax provision of taxable REIT subsidiaries
    
    $
    2
    
    
    $
    12
    
    
    $
    81
 At December 31, 2004, Capstead REIT had capital loss carryforwards for tax purposes of $70.8
million that expire after 2005. At December 31, 2004, Capsteads taxable REIT subsidiaries had net
operating loss carryforwards for tax purposes of $5.1 million, which expire after 2019, and capital
loss carryforwards of $31,000, which expire after 2006. In addition, these taxable REIT
subsidiaries have sufficient alternative minimum tax credit carryforwards to offset the payment of
federal income taxes on $5.5 million of future taxable income, if any, earned by these
subsidiaries. Because these subsidiaries are not currently expected to earn significant amounts of
taxable income, related net deferred tax assets are fully reserved at December 31, 2004.
Significant components of the Capsteads taxable REIT subsidiaries deferred income tax assets and
liabilities were as follows (in thousands): December 312004
    
    
    2003Deferred income tax assets:Alternative minimum tax credit
    
    $
    1,921
    
    
    $
    1,844Capital loss carryforwards
    
    
    11
    
    
    
    56Net operating loss carryforwards
    
    
    466
    
    
    
    455Other
    
    
    339
    
    
    
    4352,737
    
    
    
    2,790Deferred income tax liabilities
    
    
    (47
    )
    
    
    (80
    )Net deferred tax assets
    
    $
    2,690
    
    
    $
    2,710Valuation allowance
    
    $
    2,690
    
    
    $
    2,710
 NOTE 12 3⁄4 STOCKHOLDERS EQUITY As of December 31, 2004, 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. Under the terms of the governing Articles
Supplementary, common dividend distributions in excess of available quarterly net income results in
adjustments to the conversion ratios of the preferred 23




---



##### 



Capstead Mortgage Corporation shares. Capsteads preferred shares are each entitled to cumulative fixed dividends with current
conversion rates and redemption and liquidation preferences as indicated below: Per SharePreferred
    
    Annual
    
    
    Conversion
    
    
    Redemption
    
    
    LiquidationSeries
    
    Dividend
    
    
    Rate*
    
    
    Price
    
    
    PreferenceA
    
    $
    1.60
    
    
    
    1.5148
    
    
    $
    16.40
    
    
    $
    16.40B
    
    
    1.26
    
    
    
    0.5839
    
    
    
    12.50
    
    
    
    11.38
   *
    Reflects the number of common shares to be
received for each preferred share converted, effective January 1,
2005 for the Series A shares and December 31, 2004 for the Series
B shares. Series A shares totaling 9,200 were converted into
13,702 common shares during 2004. In February 2004 the Company began selling common shares into the open market on a
limited basis, resulting in the issuance of 4,812,600 common shares as of December 31, 2004. With
these sales, Capstead raised $64.1 million of new common equity during 2004 at an average price of
$13.32 per share, after expenses. Option exercises by officers and directors resulted in net additions to capital of $19,000,
$117,000, and $209,000 during 2004, 2003 and 2002 respectively. Common shares issued to management
and employees in January 2004 resulted in net additions to capital of $442,000. See NOTE 13 for
further information pertaining to employee and director stock plans. Beginning the second quarter of 2002, quarterly common dividend distributions have exceeded
available net income, primarily as a result of distributing amounts representing depreciation on
Real estate held for lease, a noncash item. The fourth quarter 2002 common dividend included a
special dividend of $7.19 per common share, representing a significant portion of the Companys
common stockholders equity. Amounts paid as regular quarterly common dividends in excess of
quarterly net income, as well as the special dividend, were recorded as reductions to Paid-in
capital. Capsteads Charter provides that if the Board of Directors 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 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. Comprehensive income is net income plus other comprehensive income or loss. Other
comprehensive income or loss currently consists of the change in unrealized gain on debt securities
classified as available-for-sale and amounts related to Derivatives held from time to time as cash
flow hedges. As of December 31, 2004, the Accumulated other comprehensive incomecomponent of
stockholders equity consisted of $24.0 million in unrealized gain on debt securities held
available-for-sale and $(192,000) in amounts related to cash flow hedges. 24




---



##### 



Capstead Mortgage Corporation The following provides information regarding comprehensive income (in thousands): Year Ended December 312004
    
    
    2003
    
    
    2002Net income
    
    $
    41,805
    
    
    $
    60,659
    
    
    $
    96,123Other comprehensive loss:Amounts related to cash flow hedges:Change in unrealized gains and losses
on cash flow hedges
    
    
    (280
    )
    
    
    (270
    )
    
    
    (113
    )Reclassification adjustment for amounts
included in net income
    
    
    (170
    )
    
    
    (101
    )
    
    
    (198
    )Amounts related to debt securities:Change in unrealized gain
    
    
    (4,473
    )
    
    
    (16,319
    )
    
    
    (2,570
    )Reclassification adjustment for amounts
included in net income
    
    
    
    
    
    
    (2,026
    )
    
    
    (1,602
    )Other comprehensive loss
    
    
    (4,923
    )
    
    
    (18,716
    )
    
    
    (4,483
    )Comprehensive income
    
    $
    36,882
    
    
    $
    41,943
    
    
    $
    91,640
 NOTE 13 3⁄4 EMPLOYEE AND DIRECTOR BENEFIT PLANS The Company sponsors stock plans to provide for the issuance of stock grants, stock
option grants and other incentive-based stock awards (collectively, the Plans). As of December
31, 2004, the Plans had 1,291,752 common shares remaining available for future issuance. In connection with 2003 incentive fee awards, in January 2004 management and employees were
issued fully vested stock grants for 27,900 common shares (grant date fair value $16.79 per share),
of which 22,500 common shares were issued to certain executive officers and are restricted from
sale until January 2007. In April 2000 stock grants for 53,577 common shares were issued to
employees (grant date fair value $14.25 per share) that vest proportionally over five years,
subject to certain restrictions including continuous employment. Stock option grants currently outstanding have terms and vesting requirements at the grant
date of up to ten years and generally have been issued with strike prices equal to the quoted
market prices of the Companys stock on the date of grant. Until discontinued in December 2004 to
conform to recently enacted tax legislation, certain outstanding stock option grants to directors
provided for the annual grant of dividend equivalent rights (DER grants) that permitted the
optionholder to obtain additional common shares at no cost upon exercise of the underlying option. Compensation costs for stock awards granted by the Company expensed pursuant to APB25 totaled
$137,000, $181,000 and $172,000 in 2004, 2003, and 2002, respectively. The effect described in
NOTE 2 of determining compensation cost for stock awards consistent with the fair value methodology
prescribed under SFAS 123 (prior to revision in December 2004), was determined using a
Black-Scholes option pricing model and, depending upon each individual option grant during the last
three years, dividend yields of 12% to 15%, volatility factors of 24% to 39%, expected life
assumptions of two to four years and risk-free rates of 1.8% to 4.6%. In measuring volatility
factors for 2004 awards, the Company considered 25




---



##### 



Capstead Mortgage Corporation volatilities experienced by other companies in the mortgage REIT industry in addition to historical
volatilities of Capstead shares given past circumstances affecting the trading of Capstead shares
not expected to reoccur. The following tables provide information regarding stock option activity
and option grants outstanding: Stock Option Activity for the Three Years ended December 31, 2004Number of
    
    
    Weighted AverageShares
    
    
    Exercise PriceAs of January 1, 2002 (241,958 exercisable)
    
    
    331,307
    
    
    $
    31.46DER grants (average fair value: $16.36 per share)
    
    
    3,072
    
    
    
    Ordinary grants (average fair value: $2.55 per share)
    
    
    11,765
    
    
    
    20.70Exercises
    
    
    (44,676
    )
    
    
    8.41Cancellations
    
    

    (1,110
    )
    
    
    11.02As of December 31, 2002 (255,685 exercisable)
    
    
    300,358
    
    
    
    33.89DER grants (average fair value: $19.75 per share)
    
    
    2,870
    
    
    
    Exercises
    
    
    (70,042
    )
    
    
    5.36Cancellations *
    
    
    (308,543
    )
    
    
    33.51Grants in connection with recapitalization *
    
    
    473,051
    
    
    
    21.43As of December 31, 2003 (all exercisable)
    
    
    397,694
    
    
    
    24.15DER grants (average fair value: $16.78 per share)
    
    
    3,744
    
    
    
    Ordinary grants (average fair value: $0.58 per share)
    
    
    10,000
    
    
    
    14.41Exercises
    
    
    (1,336
    )
    
    
    9.59Cancellations
    
    
    (62,433
    )
    
    
    19.17As of December 31, 2004 (all exercisable)
    
    
    347,669
    
    
    
    24.57
   *
    In January 2003 significant capital was returned to the common
stockholders via a special dividend distribution resulting in a recapitalization
of the Company. Accordingly, all existing options were cancelled and replaced
with new option grants for an increased number of shares at a reduced exercise
price that retained the same vesting and expiration characteristics as the
cancelled grants such that each optionholders economic position remained
unchanged subsequent to the recapitalization. The new grants are accounted for as
non-compensatory. Option Grants Outstanding as of December 31, 2004Range ofOption Grants
    
    
    Exercise
    
    
    RemainingExercise Price Group*
    
    Outstanding
    
    
    Exercisable
    
    
    Prices *
    
    
    Life (Years) *Less than $15
    
    
    82,400
    
    
    
    82,400
    
    
    $
    3.52 to $14.41
    
    
    
    1 to 9Greater than $15
    
    
    265,269
    
    
    
    265,269
    
    
    $
    19.30 to $35.37
    
    
    
    1 to 3347,669
    
    
    
    347,669
   *
    Exercise prices were adjusted for related DER grants made to directors. Weighted
average exercise prices and weighted average lives of these significant option grants were
$10.31 and seven years, and $28.98 and two years, respectively. The Company also sponsors a qualified defined contribution retirement plan for all
employees and a deferred compensation plan for certain of its officers. In general 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 $152,000, $134,000 and $96,000 in 2004, 2003 and 2002, respectively. 26




---



##### 



Capstead Mortgage Corporation NOTE 14 3⁄4 TRANSACTIONS WITH FORMER AFFILIATES Pursuant to a management contract entered into in April 2000, Fortress provided the
services of its chairman to serve as Capsteads chairman and chief executive and of other
individuals as necessary to perform support services for him. On July 22, 2003 Fortress chairman
resigned from his positions with Capstead and the management contract with Fortress was terminated.
Under the terms of the contract, Fortress was entitled to a $375,000 base annual fee and
participated with management and employees in the Companys incentive fee program. Included in
Other operating expenseis $210,000 and $375,000 of base fees paid to Fortress for services
rendered during 2003 (through July 22nd) and 2002, respectively. See NOTE 6 for
information regarding Fortress involvement through its affiliate Brookdale in the acquisition and
long-term leasing of senior living facilities acquired by Capstead in May 2002. NOTE 15 3⁄4 NET INTEREST INCOME ANALYSIS (UNAUDITED) The following summarizes interest income and interest expense and weighted average
interest rates (dollars in thousands): 2004
    
    
    2003
    
    
    2002Average
    
    
    
    
    
    
    Average

    
    
    
    
    
    
    AverageEffective
    
    
    
    
    
    
    Effective
    
    
    
    
    
    
    EffectiveAmount
    
    
    Rate
    
    
    Amount
    
    
    Rate
    
    
    Amount
    
    
    RateInterest income:Mortgage securities and similar
investments
    
    $
    84,355
    
    
    
    3.16
    %
    
    $
    85,343
    
    
    
    3.97
    %
    
    $
    150,302
    
    
    
    5.17
    %CMO collateral
    
    
    6,766
    
    
    
    6.44
    
    
    
    34,101
    
    
    
    6.20
    
    
    
    114,353
    
    
    
    6.88Total interest income
    
    
    91,121
    
    
    
    
    
    
    
    119,444
    
    
    
    
    
    
    
    264,655Interest expense:Repurchase arrangements
and similar borrowings
    
    
    38,695
    
    
    
    1.54
    
    
    
    24,606
    
    
    
    1.23
    
    
    
    48,329
    
    
    
    1.79CMOs
    
    
    6,012
    
    
    
    5.73
    
    
    
    33,926
    
    
    
    6.12
    
    
    
    116,069
    
    
    
    7.02Total interest expense
    
    
    44,707
    
    
    
    
    
    
    
    58,532
    
    
    
    
    
    
    
    164,398Net interest income
    
    $
    46,414
    
    
    
    
    
    
    $
    60,912
    
    
    
    
    
    
    $
    100,257
 Changes in interest income and interest expense due to changes in interest rates versus
changes in volume were as follows (in thousands): Rate *
    
    
    Volume *
    
    
    Total *2004/2003Interest income:Mortgage securities and similar investments
    
    $
    (19,584
    )
    
    $
    18,596
    
    
    $
    (988
    )CMO collateral
    
    
    1,282
    
    
    
    (28,617
    )
    
    
    (27,335
    )Total interest income
    
    
    (18,302
    )
    
    
    (10,021
    )
    
    
    (28,323
    )Interest expense:Repurchase arrangements and similar
borrowings
    
    
    6,981
    
    
    
    7,108
    
    
    
    14,089CMOs
    
    
    (2,068
    )
    
    
    (25,846
    )
    
    
    (27,914
    )Total interest expense
    
    
    4,913
    
    
    
    (18,738
    )
    
    
    (13,825
    )Net interest income
    
    $
    (23,215
    )
    
    $
    8,717
    
    
    $
    (14,498
    )
 27




---



##### 



Capstead Mortgage Corporation Rate *
    
    
    Volume *
    
    
    Total *2003/2002Interest income:Mortgage securities and similar investments
    
    $
    (30,532
    )
    
    $
    (34,427
    )
    
    $
    (64,959
    )CMO collateral
    
    
    (10,343
    )
    
    
    (69,909
    )
    
    
    (80,252
    )Total interest income
    
    
    (40,875
    )
    
    
    (104,336
    )
    
    
    (145,211
    )Interest expense:Repurchase arrangements and similar
borrowings
    
    
    (13,044
    )
    
    
    (10,679
    )
    
    
    (23,723
    )CMOs
    
    
    (13,302
    )
    
    
    (68,841
    )
    
    
    (82,143
    )Total interest expense
    
    
    (26,346
    )
    
    
    (79,520
    )
    
    
    (105,866
    )Net interest income
    
    $
    (14,529
    )
    
    $
    (24,816
    )
    
    $
    (39,345
    )
   *
    The change in interest income and interest expense due to both volume
and rate has been allocated to volume and rate changes in proportion to the
relationship of the absolute dollar amounts of the change in each. NOTE 16 3⁄4 QUARTERLY RESULTS (UNAUDITED) Summarized quarterly results of operations were as follows (in thousands, except per
share amounts). 1stQuarter
    
    
    2ndQuarter
    
    
    3rdQuarter
    
    
    4thQuarterYear Ended December 31, 2004Interest income
    
    $
    21,943
    
    
    $
    21,145
    
    
    $
    21,688
    
    
    $
    26,345Interest and related expense
    
    
    8,170
    
    
    
    8,693
    
    
    
    11,326
    
    
    
    16,750Net margin on financial assets
    
    
    13,773
    
    
    
    12,452
    
    
    
    10,362
    
    
    
    9,595Net margin on real estate held for lease
    
    
    513
    
    
    
    446
    
    
    
    501
    
    
    
    476Other revenue (expense)
    
    
    (1,932
    )
    
    
    (1,083
    )
    
    
    (1,376
    )
    
    
    (1,922
    )Net income
    
    $
    12,354
    
    
    $
    11,815
    
    
    $
    9,487
    
    
    $
    8,149Net income per common share:Basic
    
    $
    0.51
    
    
    $
    0.44
    
    
    $
    0.27
    
    
    $
    0.17Diluted
    
    
    0.50
    
    
    
    0.44
    
    
    
    0.27
    
    
    
    0.17Year Ended December 31, 2003Interest income
    
    $
    40,105
    
    
    $
    31,770
    
    
    $
    25,570
    
    
    $
    22,000Interest and related expense
    
    
    22,667
    
    
    
    16,563
    
    
    
    11,273
    
    
    
    8,422Net margin on financial assets
    
    
    17,438
    
    
    
    15,207
    
    
    
    14,297
    
    
    
    13,578Net margin on real estate held for lease
    
    
    502
    
    
    
    515
    
    
    
    495
    
    
    
    481Other revenue (expense)
    
    
    (397
    )
    
    
    (481
    )
    
    
    (13
    )
    
    
    (963
    )Net income
    
    $
    17,543
    
    
    $
    15,241
    
    
    $
    14,779
    
    
    $
    13,096Net income per common share:Basic
    
    $
    0.90
    
    
    $
    0.73
    
    
    $
    0.69
    
    
    $
    0.57Diluted
    
    
    0.75
    
    
    
    0.65
    
    
    
    0.63
    
    
    
    0.56
 28




---



##### 



Capstead Mortgage Corporation NOTE 17 3⁄4 MARKET AND DIVIDEND INFORMATION (UNAUDITED) The New York Stock Exchange trading symbol for Capsteads common shares is CMO. As of
December 31, 2004, the Company had 2,314 common stockholders of record and depository companies
held common shares for 29,179 beneficial owners. The high and low sales prices and dividends
declared on the common shares were as follows: Year Ended December 31, 2004
    
    
    Year Ended December 31, 2003Sales Prices
    
    
    Dividends
    
    
    Sales Prices
    
    
    DividendsHigh
    
    
    Low
    
    
    Declared
    
    
    High
    
    
    Low
    
    
    DeclaredFirst quarter
    
    $
    18.75
    
    
    $
    15.51
    
    
    $
    0.53
    
    
    $
    24.91
    
    
    $
    11.23
    
    
    $
    0.94Second quarter
    
    
    18.10
    
    
    
    11.25
    
    
    
    0.50
    
    
    
    13.27
    
    
    
    10.78
    
    
    
    0.78Third quarter
    
    
    14.85
    
    
    
    12.18
    
    
    
    0.33
    
    
    
    13.74
    
    
    
    10.85
    
    
    
    0.75Fourth quarter
    
    
    12.64
    
    
    
    10.34
    
    
    
    0.22
    
    
    
    17.98
    
    
    
    12.00
    
    
    
    0.63
 29




---



##### 



Capstead Mortgage Corporation Selected Financial Data (In thousands, except per share amounts) Year Ended December 312004
    
    
    2003
    
    
    2002
    
    
    2001
    
    
    2000Selected consolidated statement
of operations data:Interest income
    
    $
    91,121
    
    
    $
    119,444
    
    
    $
    264,655
    
    
    $
    472,696
    
    
    $
    586,585Interest and related expense
    
    
    44,939
    
    
    
    58,924
    
    
    
    164,994
    
    
    
    363,317
    
    
    
    542,150Net margin on financial assets
    
    
    46,182
    
    
    
    60,520
    
    
    
    99,661
    
    
    
    109,379
    
    
    
    44,435Net margin on real estate held for lease
    
    
    1,936
    
    
    
    1,993
    
    
    
    877
    
    
    
    
    
    
    
    Gain (loss) on asset sales, impairments
and CMO redemptions (a)
    
    
    
    
    
    
    4,560
    
    
    
    4,725
    
    
    
    7,956
    
    
    
    (89,261
    )Other revenue (expense)
    
    
    (6,313
    )
    
    
    (6,414
    )
    
    
    (9,140
    )
    
    
    (11,059
    )
    
    
    (6,660
    )Net income (loss)
    
    $
    41,805
    
    
    $
    60,659
    
    
    $
    96,123
    
    
    $
    106,276
    
    
    $
    (51,486
    )Net income
(loss) per common share:(b)Basic
    
    $
    1.34
    
    
    $
    2.89
    
    
    $
    5.47
    
    
    $
    6.43
    
    
    $
    (6.59
    )Diluted
    
    
    1.33
    
    
    
    2.60
    
    
    
    4.85
    
    
    
    5.68
    
    
    
    (6.59
    )Cash
dividends paid per share:(b)Common  regular
    
    
    1.58
    
    
    
    3.10
    
    
    
    5.56
    
    
    
    5.54
    
    
    
    1.42Common  special (c)
    
    
    
    
    
    
    
    
    
    
    7.19
    
    
    
    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
    
    
    
    1.26Average number of common shares
outstanding:(b)Basic
    
    
    16,100
    
    
    
    13,977
    
    
    
    13,858
    
    
    
    13,351
    
    
    
    11,487Diluted
    
    
    16,437
    
    
    
    23,295
    
    
    
    19,827
    
    
    
    16,956
    
    
    
    11,487Selected consolidated balance sheet data:Mortgage securities and similar investments
    
    $
    3,382,372
    
    
    $
    2,195,117
    
    
    $
    2,431,519
    
    
    $
    3,455,219
    
    
    $
    5,394,459CMO collateral
    
    
    56,187
    
    
    
    167,571
    
    
    
    1,083,421
    
    
    
    2,262,305
    
    
    
    3,126,878Real estate held for lease
    
    
    129,705
    
    
    
    133,414
    
    
    
    137,122
    
    
    
    
    
    
    
    Total assets
    
    
    3,687,982
    
    
    
    2,554,322
    
    
    
    3,766,928
    
    
    
    5,895,425
    
    
    
    8,610,497Repurchase arrangements and similar
borrowings
    
    
    3,166,059
    
    
    
    1,975,178
    
    
    
    2,145,656
    
    
    
    3,207,068
    
    
    
    4,904,632Collateralized mortgage obligations
    
    
    55,735
    
    
    
    166,807
    
    
    
    1,074,779
    
    
    
    2,245,015
    
    
    
    3,103,874Borrowings secured by real estate
    
    
    120,001
    
    
    
    120,206
    
    
    
    120,400
    
    
    
    
    
    
    
    Stockholders equity (c)
    
    
    332,539
    
    
    
    277,038
    
    
    
    298,578
    
    
    
    404,728
    
    
    
    545,669Book value per common share (c)
    
    $
    7.91
    
    
    $
    6.67
    
    
    $
    8.23
    
    
    $
    15.87
    
    
    $
    28.42
   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)
    Results in 2000 include losses on the sale and impairment of financial assets incurred
with the modification of the Companys investment strategy to focus primarily on
adjustable-rate financial assets.(b)
    Amounts have been adjusted for 1-for-2 reverse common stock splits effective in July
2001 and May 2000.(c)
    In 2002 and 2001 Capstead declared special common dividends aggregating $302 million,
which significantly reduced stockholders equity and book value per common share. Both
special dividends were recorded as reductions to Paid-in Capital. 30




---



##### 



Capstead Mortgage Corporation   Managements Discussion and Analysis of FinancialCondition 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 primarily consist of, but
are not limited to, residential adjustable-rate mortgage (ARM) 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 real estate-related
assets, including the direct ownership of real estate. Management believes such investments, when
available at favorable prices and combined with the prudent use of leverage, can produce attractive
risk-adjusted returns over the long term with relatively low sensitivity to changes in interest
rates. The size and composition of Capsteads investment portfolios depend on investment strategies
being implemented by management, the availability of attractively-priced investments and overall
market conditions. Market conditions are influenced by, among other things, current levels of, and
expectations for future levels of, 30-day to two-year interest rates and mortgage prepayments.
Since the latter half of 2003, Capstead acquired sufficient ARM securities to more than replace
portfolio runoff for the first time in several years. During 2004 the Company acquired over $2.0
billion in ARM securities, increasing the size of the mortgage securities and similar investments
portfolio to nearly $3.4 billion from $2.2 billion at the previous year-end. These acquisitions
further deployed existing capital, as well as new common equity capital raised during the year.
The Company intends to continue pursuing the acquisition of attractively-priced ARM securities,
while also investigating other real estate-related opportunities. In February 2004 the Company began selling common shares into the open market on a limited
basis, resulting in the issuance of over 4.8 million common shares and increasing common shares
outstanding by over 34%. With these sales, Capstead raised $64.1 million of new common equity at
an average price of $13.32 per share, after expenses. Importantly, these sales were highly
accretive to the book value of existing common stockholders because the shares were issued at a
substantial premium to book value and the capital raised in this manner was quickly deployed into
new investments, resulting in minimal dilution to earnings compared to delays typically experienced
deploying large amounts of new capital raised in more traditional stock offerings. If market
conditions allow, the Company may raise more new capital in 2005 to fund additional investments. Beginning on June 30, 2004, in response to growth expectations for the United States economy, the
Federal Reserves Federal Open Market Committee (the Federal Reserve) has acted to increase
short-term interest rates by raising the federal funds rate 25 basis points at each of its last six
meetings (including the February 2005 meeting) and is expected to further increase rates at future
meetings. Higher short-term interest rates are increasing the Companys borrowing costs, thereby
reducing financing spreads (the difference between 31




---



##### 



Capstead Mortgage Corporation yields earned on the Companys mortgage investments and interest rates charged on related
borrowings). The effects of rising borrowing costs on financing spreads can eventually be
mitigated by ARM security yield increases. However, interest rates on the Companys borrowings
rise (and fall) almost immediately while ARM security yields change slowly by comparison because
the coupon interest rates on the underlying loans generally reset only once a year and the amount
of each reset can be limited or capped. Consequently, as increasing short-term interest rates
reduce current financing spreads, earnings and dividends may decline in the immediately ensuing
quarters before the benefits of ARM security yield increases are fully realized. Risk Factors and Critical Accounting Policies Under the captions Effects of Interest Changes, Risks Associated with Credit-Sensitive
Investments, Risks Associated with Owning Real Estate, Regulatory Matters and Critical
Accounting Policies are discussions of risk factors and critical accounting policies affecting
Capsteads financial condition and results of operations that are an integral part of this
discussion and analysis. Readers are strongly urged to consider the potential impact of these
factors and accounting policies on the Company while reading this document. Book Value Per Common Share As of December 31, 2004, Capsteads book value per common share was $7.91, an increase of
$1.24 during the year. Increases in book value from raising common equity capital at prices in
excess of book value more than offset a decline in the aggregate unrealized gain on the Companys
mortgage investments portfolio caused largely by portfolio runoff and dividend payments in excess
of net income. Common stock issuances contributed $1.71 per share to book value while the decline
in the aggregate unrealized gain on the Companys investments (most of which are debt securities
carried at fair value with changes in fair value reflected in stockholders equity) and other
elements of accumulated other comprehensive income lowered book value by $0.25 per share. Dividend
payments in excess of net income, which occur primarily because the Company currently distributes
all cash flow from its net-leased real estate, lowered book value by $0.22 per share. The unrealized gain on the Companys mortgage investments portfolio can be expected to
fluctuate with changes in portfolio size and composition, as well as changes in interest rates and
market liquidity. Such changes will largely be reflected in book value per common share. Book
value will also be affected by other factors, including capital stock transactions and the level of
dividend distributions relative to quarterly net income; however, temporary changes in fair values
of investments not carried at fair value on the Companys balance sheet generally will not affect
book value. Mortgage Securities and
Similar Investments
     As of December 31, 2004, the mortgage securities and similar investments portfolio consisted
primarily of ARM Agency Securities. ARM securities held by the Company are backed by mortgage
loans that have interest rates that adjust at least annually to more current interest rates
(current-reset ARM securities) or begin doing so after an initial fixed-rate period
(longer-to-reset ARM securities). Agency Securities are AAA-rated and are 32




---



##### 



Capstead Mortgage Corporation considered to have limited credit risk. Non-agency securities are private mortgage pass-through
securities whereby the related credit risk of the underlying loans is borne by AAA-rated private
mortgage insurers or by the Company (Non-agency Securities). Commercial mortgage-backed
securitizations generally have senior, mezzanine and subordinate classes of bonds with the lower
classes providing credit enhancement to the more senior classes. Commercial mortgage-backed
securities (CMBS) held by the Company at December 31, 2004 are adjustable-rate 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. Mortgage securities held by
Capstead are financed under repurchase arrangements with investment banking firms pursuant to which
specific securities are pledged as collateral. Should the Company acquire financial assets that
are not mortgage-backed securities, similar financing arrangements with other parties, such as
commercial banks, may be employed (see Liquidity and Capital Resources). The following yield and cost analysis illustrates results achieved during 2004 for components
of the mortgage securities and similar investments portfolio and anticipated first quarter 2005
asset yields and borrowing rates based on existing portfolio composition and yield curve
characteristics in effect on January 27, 2005 (the date fourth quarter 2004 results were publicly
released) (dollars in thousands): 2004 Average
    
    
    As of December 31, 2004
    
    
    Projected
    
    
    LifetimeActual
    
    
    Actual
    
    
    Premiums
    
    
    
    
    
    
    1stQuarter
    
    
    RunoffBasis(a)
    
    
    Yield/Cost
    
    
    Runoff
    
    
    (Discounts)
    
    
    Basis(a)
    
    
    Yield/Cost(b)
    
    
    AssumptionsAgency Securities:Fannie Mae/Freddie Mac:Fixed-rate
    
    $
    33,770
    
    
    
    6.13
    %
    
    
    36
    %
    
    $
    146
    
    
    $
    35,684
    
    
    
    6.26
    %
    
    
    39
    %ARMs
    
    
    1,493,506
    
    
    
    3.01
    
    
    
    28
    
    
    
    39,572
    
    
    
    2,156,026
    
    
    
    3.30
    
    
    
    33Ginnie Mae ARMs
    
    
    948,623
    
    
    
    3.15
    
    
    
    27
    
    
    
    7,583
    
    
    
    1,025,100
    
    
    
    3.18
    
    
    
    292,475,899
    
    
    
    3.10
    
    
    
    28
    
    
    
    47,301
    
    
    
    3,216,810
    
    
    
    3.29
    
    
    
    32Non-agency Securities:Fixed-rate
    
    
    57,884
    
    
    
    6.20
    
    
    
    39
    
    
    
    24
    
    
    
    34,362
    
    
    
    6.40
    
    
    
    38ARMs
    
    
    67,558
    
    
    
    3.24
    
    
    
    31
    
    
    
    646
    
    
    
    56,261
    
    
    
    3.82
    
    
    
    37125,442
    
    
    
    4.61
    
    
    
    35
    
    
    
    670
    
    
    
    90,623
    
    
    
    4.79
    
    
    
    37CMBS
    
    
    63,052
    
    
    
    2.47
    
    
    
    10
    
    
    
    10
    
    
    
    51,169
    
    
    
    3.69
    
    
    
    12,664,393
    
    
    
    3.16
    
    
    
    29
    
    
    $
    47,981
    
    
    
    3,358,602
    
    
    
    3.34
    
    
    
    31Borrowings:30-day LIBOR
    
    
    2,191,544
    
    
    
    1.46
    
    
    
    
    
    
    
    
    
    
    
    2,460,311
    
    
    
    2.58>30-day LIBOR
    
    
    273,523
    
    
    
    2.27
    
    
    
    
    
    
    
    
    
    
    
    705,748
    
    
    
    2.452,465,067
    
    
    
    1.54
    
    
    
    
    
    
    
    
    
    
    
    3,166,059
    
    
    
    2.55Capital employed/

financing spread
    
    $
    199,326
    
    
    
    1.62
    
    
    
    
    
    
    
    
    
    
    $
    192,543
    
    
    
    0.79Return on assets (c)
    
    
    
    
    
    
    1.71
    
    
    
    
    
    
    
    
    
    
    
    
    

    
    
    0.98
   (a)
    Basis represents the Companys investment before unrealized gains and losses.(b)
    Projected annualized yields for the first quarter of 2005 reflect ARM coupon resets and
lifetime runoff assumptions as adjusted for expected runoff for this quarter only, as of
January 27, 2005. Actual yields realized in future periods will largely depend upon (i)
changes in portfolio composition, (ii) ARM coupon resets, (iii) actual runoff and (iv) any
changes in lifetime runoff assumptions. Projected interest rates on borrowings that reset
every 30 days at the 30-day London Interbank Offered Rate (LIBOR) reflect the 25 basis
point increase in the federal funds rate on February 2, 2005 and expectations for an
additional 25 basis point increase at the March 22, 2005 Federal Reserve meeting.(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 Potential Liquidity). The Companys mortgage securities and similar investments portfolio increased during 2004 to
nearly $3.4 billion from $2.2 billion at December 31, 2003 after several years of declines.
Acquisitions totaled over $2.0 billion during 2004 and consisted almost exclusively 33




---



##### 



Capstead Mortgage Corporation of ARM Agency Securities. Portfolio runoff for the year totaled $881 million. Annualized
portfolio runoff rates moderated somewhat to 29% during 2004 from 34% the prior year. The Company
has had continued success subsequent to year-end acquiring additional ARM securities and expects to
replace portfolio runoff during the first quarter of 2005; however, there can be no assurance that
attractively-priced ARM securities will continue to be available. To the extent the proceeds of
mortgage prepayments and other maturities are not reinvested or cannot be reinvested at a rate of
return on invested capital at least equal to the return earned on previous investments, earnings
and common dividends may decline. The future size and composition of the Companys investment
portfolios will depend on market conditions, including levels of mortgage prepayments and the
availability of attractively-priced investments. Financing spreads declined 112 basis points during 2004 to average 1.62% for the year. The
overall yield earned on the portfolio averaged 3.16% in 2004, compared to an average yield of 3.97%
earned the prior year. Yields on current-reset ARM securities fluctuate as coupon interest rates
on underlying mortgage loans reset periodically to a margin over a current short-term interest rate
index (typically, a one-year index), generally subject to periodic and lifetime limits or caps.
After several years of quarterly declines, portfolio yields improved 16 basis points during the
fourth quarter of 2004 and coupon interest rate resets are expected to continue trending higher in
the aggregate, contributing to improving portfolio yields. For example, based on interest rate
expectations as of January 27, 2005, existing portfolio yields are expected to improve 18 basis
points to approximately 3.34% for the first quarter of 2005. By the fourth quarter of 2005, the
average yield on the existing portfolio will likely exceed 4.00%. Yields are also affected by
mortgage prepayments, which impact how quickly purchase premiums are amortized to earnings. Actual
yields will depend on portfolio composition as well as fluctuations in, and market expectations for
fluctuations in, interest rates and mortgage prepayments. Average rates on borrowings secured by mortgage investments averaged 2.08% during the fourth
quarter of 2004 and 1.54% during all of 2004 compared to 1.23% during 2003 and are expected to
increase further in 2005. Since June 2004 the Federal Reserve has acted to increase short-term
interest rates by raising the federal funds rate a total of 150 basis points (including the 25
basis point increase in February 2005) and is expected to continue to increase rates in response to
current growth expectations for the United States economy. In light of these market conditions,
during 2004 the Company extended maturities for up to two years on a portion of its borrowings,
which effectively locked in attractive financing spreads on the Companys modest position in
fixed-rate securities and longer-to-reset ARM securities over the average expected fixed-rate terms
of these investments. As of December 31, 2004 over $700 million of these borrowings were
outstanding with maturities averaging 13 months and rates averaging less than current 30-day
borrowing rates. Interest rates on the rest of the Companys short-term borrowings remain largely
dependent on 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 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 residential
mortgage loans. The last CMO issued by the Company was in 2000 and the Company does not currently
anticipate issuing additional CMOs. In prior years, the 34




---



##### 



Capstead Mortgage Corporation Company periodically exercised its right to redeem previously issued CMOs (referred to as Clean-up
Calls) selling some of the released collateral and holding the rest for investment as part of the
Non-Agency Securities portfolio. As of December 31, 2004, the Company held Clean-up Call rights on
only one of its five remaining CMOs. Consequently, additional gains from CMO redemptions are not
anticipated. CMO collateral net of related bonds totaled $452,000 at December 31, 2004, compared
to $764,000 at December 31, 2003. Without the issuance of CMOs in which the Company retains
residual interests, this portfolio is not expected to contribute significantly to operating results
in future periods. Real Estate Held For Lease In May 2002 Capstead acquired six independent senior living properties wherein the operator
of the facility provides tenants little, if any, medical care (the Properties). Concurrent with
the acquisition of the Properties, the Company entered into a long-term net-lease arrangement
(the Lease) with Brookdale Living Communities, Inc., (Brookdale), under which Brookdale is
responsible for the ongoing operation and management of the Properties. Brookdale, an owner,
operator, developer and manager of senior living facilities, is a majority-owned affiliate of
Fortress Investment Group LLC (see NOTE 14 to the accompanying consolidated financial statements).
Real estate held for lease and related assets, net of accumulated depreciation, related borrowings
and other related liabilities, totaled $20.9 million at December 31, 2004 compared to $30.0 million
at December 31, 2003. The following table summarizes information about the Properties: YearProperty
    
    Location
    
    Units(a)
    
    
    Occupancy(b)

    
    OpenedChambrel at Roswell
    
    Roswell, GA
    
    280 (256 IL; 24 AL)
    
    
    98.9
    %
    
    
    1987Chambrel at Pinecastle
    
    Ocala, FL
    
    161 (120 IL; 41 AL)
    
    
    100.0
    
    
    
    1987Chambrel at Island Lake
    
    Longwood, FL
    
    269 (229 IL; 40 AL)
    
    
    97.4
    
    
    
    1985Chambrel at Montrose
    
    Akron, OH
    
    168 (136 IL; 32 AL)
    
    
    96.4
    
    
    
    1987Chambrel at Williamsburg
    
    Williamsburg, VA
    
    255 (200 IL; 55 AL)
    
    
    99.6
    
    
    
    1987Chambrel at Club Hill
    
    Garland, TX
    
    260 (192 IL; 68 AL)
    
    
    90.8
    
    
    
    1987Total
    
    
    
    1,393 (1,133 IL; 260 AL)
    
    
    97.1
   (a)
    IL refers to Independent Living units and AL refers to Assisted Living units.(b)
    As of December 31, 2004. The Lease has an initial term of 20 years and provides for two 10-year renewal periods.
Beginning in May 2007, Brookdale will have the option of purchasing all of the Properties from
Capstead at the greater of fair value or Capsteads original cost, after certain adjustments.
Under the terms of the Lease, Brookdale is responsible for paying all expenses associated with
operating the Properties, including real estate taxes, other government charges, insurance,
utilities and maintenance, and an amount representing an attractive cash return on Capsteads
equity in the Properties after payment of monthly debt service. In keeping with Capsteads
strategy of investing in assets that can produce attractive returns over the long term with less
sensitivity to changes in interest rates, changes in monthly debt service requirements are the
responsibility of Brookdale under the terms of the Lease. 35




---



##### 



Capstead Mortgage Corporation Utilization of Capital and Potential Liquidity The Company generally finances its mortgage securities and similar investments with
well-established investment banking firms using repurchase arrangements and similar borrowings.
Assuming potential liquidity is available, these borrowings can be increased or decreased on a
daily basis to meet cash flow requirements and otherwise manage capital resources efficiently. CMO
collateral is pledged to secure CMO bonds. Real estate held for lease and related assets are
pledged to secure long-term borrowings. Although Capstead has no responsibility for CMO bonds or
borrowings secured by real estate beyond these assets, nor do they represent a potential source of
liquidity through further borrowings. Potential 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). The
following table illustrates Capsteads utilization of capital and potential liquidity as of
December 31, 2004 in comparison with December 31, 2003 (in thousands): Capital
    
    
    PotentialAssets(a)
    
    
    Borrowings
    
    
    Employed
    
    
    Liquidity(a)Mortgage securities and similar
investments:Agency Securities
    
    $
    3,240,011
    
    
    $
    3,046,503
    
    
    $
    193,508
    
    
    $
    95,548Non-agency Securities
    
    
    91,154
    
    
    
    71,140
    
    
    
    20,014
    
    
    
    14,198CMBS
    
    
    51,207
    
    
    
    48,416
    
    
    
    2,791
    
    
    
    (126
    )3,382,372
    
    
    
    3,166,059
    
    
    
    216,313
    
    
    
    109,620CMO collateral and investments
    
    
    56,187
    
    
    
    55,735
    
    
    
    452
    
    
    
    Real estate held for lease (b)
    
    
    140,921
    
    
    
    120,001
    
    
    
    20,920
    
    
    
    $
    3,579,480
    
    
    $
    3,341,795
    
    
    
    237,685
    
    
    
    109,620Other assets, net of other liabilities
    
    
    
    
    
    
    
    
    
    
    99,005
    
    
    
    73,030
    (c)Fourth quarter common dividend
    
    
    
    
    
    
    
    
    
    
    (4,151
    )
    
    
    (4,151)
    (d)Targeted liquidity reserves for funding
principal payments and margin calls
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (168,716
    )$
    332,539
    
    
    $
    9,783Balances of as December 31, 2003
    
    $
    2,512,910
    
    
    $
    2,262,191
    
    
    $
    277,038
    
    
    $
    44,999
   (a)
    Assets are stated at carrying amounts on the Companys balance sheet. Potential
liquidity is based on maximum amounts of borrowings available under existing uncommitted
repurchase arrangements considering the fair value of related collateral as of the
indicated dates, adjusted separately for targeted liquidity reserves.(b)
    Real estate held for lease includes related assets and is net of accumulated depreciation
and other related liabilities.(c)
    Represents unrestricted cash and cash equivalents.(d)
    The fourth quarter 2004 common dividend was declared December 15, 2004 and paid January 22,
2005 to stockholders of record as of December 31, 2004. During 2004, Capstead had invested proceeds from portfolio runoff and capital raising
activities, and a portion of its available liquidity, into additional ARM securities. With the
resulting growth of the mortgage securities and similar investments portfolio, targeted liquidity
reserves have increased correspondingly to $169 million at December 31, 2004 from $115 million at
December 31, 2003. Targeted liquidity reserves reflect managements determination, as of the
balance sheet date, of the level of capital necessary to hold in reserve to fund margin calls
(requirements to pledge additional collateral or pay down borrowings) required by principal
payments (that are not remitted to the Company for 25 to 45 days after any given month-end) and
potential declines in market value of pledged assets under stressed market conditions. 36




---



##### 



Capstead Mortgage Corporation Contractual Obligations The following table lists Capsteads contractual obligations, including related interest
obligations through maturity, as of December 31, 2004 (in thousands): Payments Due by PeriodGreater12 Months
    
    
    12 - 36
    
    
    37 - 60
    
    
    ThanContractual Obligations
    
    Total
    
    
    or Less
    
    
    Months
    
    
    Months
    
    
    60 MonthsRepurchase arrangements
and similar borrowings
    
    $
    3,193,064
    
    
    $
    2,742,594
    
    
    $
    450,470
    
    
    $
    
    
    
    $
    CMO borrowings
    
    
    59,699
    
    
    
    37,793
    
    
    
    14,324
    
    
    
    4,982
    
    
    
    2,600Borrowings secured by
real estate
    
    
    221,486
    
    
    
    6,163
    
    
    
    12,591
    
    
    
    12,985
    
    
    
    189,747Corporate office lease
    
    
    1,428
    
    
    
    300
    
    
    
    564
    
    
    
    564
    
    
    
    $
    3,475,677
    
    
    $
    2,786,850
    
    
    $
    477,949
    
    
    $
    18,531
    
    
    $
    192,347
 For variable-rate borrowings the interest component of these obligations is based on
rates in effect at year-end. Payments due by period on CMOs reflect current expectations of
mortgage prepayments on related pledged collateral and the exercise of Clean-up Calls. This
presentation excludes acquisitions of financial assets and any other contractual obligations
entered into after year-end. Tax Considerations of Dividends Paid on Capstead Shares Preferred share dividend distributions for the last three years have consisted entirely of
ordinary taxable income. Each common share dividend distribution (including a $7.19 special common
dividend declared in December 2002 and distributed in January 2003) is allocated between ordinary
taxable income, capital gain and return of capital based on the relative amounts of Capsteads
taxable income (by category, after consideration of available capital loss carryforwards and
allocations to preferred shares) to total distributions for each year. Stockholders should reduce
the tax cost basis of their shares by the amount of return of capital distributions received, if
any. 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 dividends received. The
following table provides tax characteristics of Capsteads common share dividend distributions for
the last three years: Common

    
    Capital

    
    Ordinary

    
    Return ofTax Year
    
    Dividends

    
    Gain *

    
    Income *

    
    Capital *2004
    
    $
    1.58
    
    
    
    
    %
    
    
    86.08
    %
    
    
    13.92
    %2003
    
    
    3.10
    
    
    
    
    
    
    
    100.00
    
    
    
    2002
    
    
    12.75
    
    
    
    
    
    
    
    41.25
    
    
    
    58.75
   *
    The indicated characterization percentage is applicable to each quarterly or special common
dividend received with respect to a given tax year. This includes fourth quarter dividends
declared prior to year-end with a December record date and paid in January of the following year in
accordance with the Internal Revenue Code spillover distribution provision (IRC Section875(b)(9)).
Dividend characterization information for tax years prior to 2002 is available at
www.capstead.com. 37




---



##### 



Capstead Mortgage Corporation   RESULTS OF OPERATIONS Comparative net operating results (interest income or lease revenue, net of related
interest expense) by source were as follows (in thousands, except per share amounts): Year Ended December 312004
    
    
    2003
    
    
    2002Mortgage securities and similar investments:Agency Securities
    
    $
    40,824
    
    
    $
    51,288
    
    
    $
    91,769Non-agency Securities
    
    
    4,011
    
    
    
    6,091
    
    
    
    4,270CMBS and other commercial loans
    
    
    640
    
    
    
    3,099
    
    
    
    5,598CMO collateral
    
    
    707
    
    
    
    42
    
    
    
    (1,976
    )Net margin on financial assets
    
    
    46,182
    
    
    
    60,520
    
    
    
    99,661Real estate held for lease:Lease revenue net of related interest expense
    
    
    5,644
    
    
    
    5,701
    
    
    
    3,420Real estate depreciation
    
    
    (3,708
    )
    
    
    (3,708
    )
    
    
    (2,543
    )Net margin on real estate held for lease
    
    
    1,936
    
    
    
    1,993
    
    
    
    877Other revenue (expense):Gain on asset sales and CMO redemptions
    
    
    
    
    
    
    4,560
    
    
    
    4,725CMO administration and other
    
    
    813
    
    
    
    1,784
    
    
    
    2,429Incentive fee paid to former affiliate
    
    
    
    
    
    
    (500
    )
    
    
    (4,982
    )Other operating expense
    
    
    (7,126
    )
    
    
    (7,698
    )
    
    
    (6,587
    )Total other revenue (expense)
    
    
    (6,313
    )
    
    
    (1,854
    )
    
    
    (4,415
    )Net income
    
    
    41,805
    
    
    
    60,659
    
    
    
    96,123Less cash dividends paid on preferred stock
    
    
    (20,259
    )
    
    
    (20,273
    )
    
    
    (20,362
    )Net income available to common stockholders
    
    $
    21,546
    
    
    $
    40,386
    
    
    $
    75,761Operating income *
    
    $
    25,581
    
    
    $
    39,876
    
    
    $
    73,987Weighted average shares outstanding:Basic
    
    
    16,100
    
    
    
    13,977
    
    
    
    13,858Diluted
    
    
    16,437
    
    
    
    23,295
    
    
    
    19,827Operating *
    
    
    16,437
    
    
    
    14,327
    
    
    
    14,175Net income per common share:Basic
    
    $
    1.34
    
    
    $
    2.89
    
    
    $
    5.47Diluted
    
    
    1.33
    
    
    
    2.60
    
    
    
    4.85Operating *
    
    
    1.56
    
    
    
    2.78
    
    
    
    5.22Regular common dividends declared per share
    
    $
    1.58
    
    
    $
    3.10
    
    
    $
    5.56
   *
    Capstead reports operating income per common share (a non-GAAP financial measure
calculated excluding depreciation on real estate, any gain on asset sales and CMO
redemptions, and the dilutive effects, if present, of the Series B preferred shares) under
the belief it provides investors with a useful supplemental measure of the Companys
operating performance. Operating income represents a measure of the amount of funds
generated by operations, which may, at the discretion of Capsteads Board of Directors, be
used for reinvestment or distributed to common stockholders as dividends. Depreciation on
real estate, although an expense deductible for federal income tax purposes and therefore
an item that reduces Capsteads REIT distribution requirements, is added back to arrive at
operating income because it is a noncash expense. Gains are excluded because they are
considered non-operating in nature and the amount and timing of any such gains are
dependent upon investment strategies and market conditions. The Series B preferred shares
are considered dilutive, for diluted net income per common share purposes only, whenever
annualized basic net income per common share exceeds $2.16 (the Series B preferred share
annualized dividend of $1.26 divided by the current conversion rate of 0.5839). Operating
income per common share excludes the dilutive effects, if present, of the Series B
preferred shares because it is not economically advantageous to convert these shares at
market prices of both the common shares and Series B preferred shares; therefore few, if
any, Series B preferred share conversions are expected. 38




---



##### 



Capstead Mortgage Corporation   Net margins on financial assets and related financing spreads benefited significantly in
prior years from actions taken by the Federal Reserve beginning in 2001 to lower short-term
interest rates, which resulted in significantly lower interest rates on the Companys borrowings
even as lower interest rates also led to steadily declining yields on the Companys adjustable-rate
assets and relatively high mortgage prepayment rates. This trend of declining asset yields
reversed during the fourth quarter of 2004 leading to a quarter-over-quarter increase in overall
portfolio yields for the first time since the fourth quarter of 2000. Given current expectations
for interest rates, portfolio yields are expected to continue trending higher in the coming
quarters. Short-term interest rates began increasing in June 2004 in response to Federal Reserve actions
to raise the federal funds rate. These higher rates resulted in significantly higher borrowing
rates contributing to declining net margins and financing spreads for the Company. This
illustrates how the Company is impacted immediately when short-term interest rates rise (and fall)
while ARM security yields change slowly in comparison because coupon interest rates on the
underlying mortgage loans generally reset only once a year and the amount of each reset can be
limited or capped. Because the majority of Capsteads financial asset portfolios currently consist of ARM
securities, management believes Capstead is well positioned to manage through the anticipated
higher interest rate environment, albeit at reduced financing spreads and, therefore, at a reduced
earnings level than that achieved the last several years when short-term interest rates were
declining. See Financial Condition  Overview and Mortgage Securities and Similar Investments
for further discussion of the current operating environment. Key operating statistics for each component of the mortgage securities and similar investments
portfolio were as follows (dollars in millions): Year Ended December 312004
    
    
    2003
    
    
    2002Agency Securities:Average portfolio outstanding
    
    $
    2,476
    
    
    $
    1,867
    
    
    $
    2,617Yields
    
    
    3.10
    %
    
    
    3.88
    %
    
    
    5.16
    %Borrowing rates
    
    
    1.54
    
    
    
    1.17
    
    
    
    1.75Financing spreads
    
    
    1.56
    
    
    
    2.71
    
    
    
    3.41Portfolio runoff rates (annualized)
    
    
    27.95
    
    
    
    31.83
    
    
    
    31.75Non-Agency Securities:Average portfolio outstanding
    
    $
    125
    
    
    $
    163
    
    
    $
    91Yields
    
    
    4.61
    %
    
    
    4.63
    %
    
    
    5.62
    %Borrowing rates
    
    
    1.73
    
    
    
    1.49
    
    
    
    1.87Financing spreads
    
    
    2.88
    
    
    
    3.14
    
    
    
    3.75Portfolio runoff rates (annualized)
    
    
    34.96
    
    
    
    40.09
    
    
    
    28.10CMBS and other commercial loans:Average portfolio outstanding
    
    $
    63
    
    
    $
    114
    
    
    $
    192Yields
    
    
    2.47
    %
    
    
    4.44
    %
    
    
    4.97
    %Borrowing rates
    
    
    1.56
    
    
    
    1.99
    
    
    
    2.44Financing spreads
    
    
    0.91
    
    
    
    2.45
    
    
    
    2.53Portfolio runoff rates (annualized)
    
    
    10.37
    
    
    
    23.93
    
    
    
    38.65
 39




---



##### 



Capstead Mortgage Corporation 2004 Compared to 2003 Agency Securities were the primary contributor to operating results during 2004 compared to
2003; however, the impact of lower financing spreads was evident in current year results, which
were less than in 2003 despite a higher average portfolio outstanding during 2004. Non-Agency
Securities contributed less to operating results during 2004 primarily because of a lower average
portfolio outstanding but results were also negatively affected by lower financing spreads. This
portfolio declined with runoff and the securitization and transfer of $53 million of high coupon
fixed-rate Non-Agency Securities into Fannie Mae Agency Securities in March 2004. CMBS and other
commercial loans contributed significantly less to operating results during 2004 due largely to
payoffs of higher yielding components of this portfolio. CMO collateral balances have declined significantly the last several years primarily because
of high mortgage prepayments and the exercise of Clean-up Calls. Having redeemed in prior years
all but one of the outstanding CMOs to which the Company holds the related Clean-up Call rights,
Capstead did not realize any gain on asset sales and CMO redemptions during 2004. With these
redemptions of relatively high cost fixed-rate CMOs, CMO results improved in 2004 even as CMO
collateral balances have declined. With continued runoff of this portfolio, future contributions
to operating results are expected to decline. CMO administration revenue continues to trend lower primarily because of a declining portfolio
of CMOs for which the Company provides administrative services. As these CMOs continue to pay down
or are redeemed, related fee income will decline further. Other revenue was lower in 2004 due
primarily to the prior year recovery of a $500,000 insurance deductible related to the October 2003
dismissal with prejudice of a purported class action lawsuit filed against the Company and its key
officers in 1998. Other operating expense (including incentive fees payable to former affiliate) were lower in
2004 compared to 2003 primarily because of lower current year accruals for incentive fees. Lower
incentive fee accruals primarily reflect lower 2004 earnings and dividends. Because the incentive
fee formula considers increases in book value resulting from capital raising activities separately,
2004 incentive fees were also lower due to the effects on book value of declines in unrealized
gains on mortgage securities caused largely by portfolio runoff. See NOTE 2 to the accompanying
consolidated financial statements. 2003 Compared to 2002 The impact of lower yields and a significantly lower average outstanding portfolio was evident
in the contribution Agency Securities made to 2003 results, which was significantly less than in
2002 despite lower borrowing rates. Conversely, Non-agency Securities contributed more to
operating results during 2003 than in 2002, despite lower financing spreads, primarily because of
the benefits of additional securities made available from the redemption of CMOs. CMBS and other
commercial loans contributed less to operating results during 2003 than in 2002 primarily because
of a lower average outstanding portfolio due largely to payoffs early in 2003 of several positions
held throughout all of 2002. CMO collateral results improved in 2003 over 2002 due largely to declines in recent years in
relatively high cost fixed-rate CMOs, due largely to high mortgage prepayments and the exercise of
Clean-up Calls. 40




---



##### 



Capstead Mortgage Corporation In May 2002 the Company made its first direct investment in real estate that is net-leased on
a long-term basis. Under the terms of the Lease, changes in interest rates on the related debt are
the responsibility of the lessee. Results in 2003 were higher than in 2002 primarily because the
properties were owned for a full year in 2003 compared to only eight months in 2002. Gain on asset sales and CMO redemptions in 2003 reflects a gain of $4.0 million on the sale of
$121 million of released CMO collateral and a net gain of $545,000 on the redemption of CMO bonds
related to $195 million in collateral held as Non-agency Securities upon release from the related
indentures. CMO administration revenue continues to trend lower primarily because of a declining portfolio
of CMOs for which the Company provides administrative services. Although earnings from overnight
investments were significantly less in 2003, other revenue benefited from the recovery of a
$500,000 insurance deductible related to the October 2003 dismissal with prejudice of a purported
stockholder class action lawsuit filed against the Company and its key officers in 1998. On a combined basis, incentive fees paid to former affiliate and other operating expenses were
considerably less during 2003 than in 2002. This reflects lower current year accruals for
incentive fees primarily because of lower earnings and dividends and declines in book value caused
largely by portfolio runoff. See NOTE 2 to the accompanying consolidated financial statements. LIQUIDITY AND CAPITAL RESOURCES Capsteads primary sources of funds are borrowings under repurchase arrangements and
monthly principal and interest payments on mortgage securities and similar investments. Other
sources of funds include proceeds from other borrowing arrangements, proceeds from asset sales,
unrestricted payments received on real estate held for lease and proceeds from equity offerings.
The Company generally uses its liquidity to pay down borrowings under repurchase arrangements to
reduce borrowing costs and otherwise efficiently manage its capital. Because the level of these
borrowings can be adjusted on a daily basis, the level of unrestricted cash and cash equivalents
carried on the balance sheet is less important than the Companys potential liquidity available
under its borrowing arrangements. The table included under Financial Condition  Utilization of
Capital and Potential Liquidity and accompanying discussion illustrates additional funds
potentially available to the Company as of December 31, 2004, as adjusted for targeted liquidity
reserves. The Company currently believes that it has ample liquidity and capital resources
available for the acquisition of additional 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
totaled $3.1 billion at December 31, 2004. These borrowings generally have maturities of less than
31 days, although from time to time the Company may enter into longer-term arrangements as it did
on a significant portion of these borrowings during 2004 (see discussion above under Mortgage
Securities and Similar Investments). Capstead has uncommitted repurchase facilities with
investment banking firms to finance these investments, subject to certain conditions. Interest
rates on these borrowings are generally 41




---



##### 



Capstead Mortgage Corporation based on 30-day London Interbank Offered Rate (LIBOR) (or a corresponding benchmark rate for
longer-term arrangements) 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. Borrowings under repurchase arrangements with investment banking firms secured by CMBS
acquired in 2002 and 2001 more closely match the interest rate adjustment features of these
investments such that the Company has earned more consistent financing spreads and, as a result,
experienced less interest rate volatility than experienced with investments in Agency Securities.
These borrowings, which originally had longer initial maturities than most borrowings secured by
Agency Securities, totaled $48 million at December 31, 2004. Should Capstead make significant
additional investments in credit-sensitive 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. CMO borrowings totaled $56 million at December 31, 2004 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. Mortgage prepayments and
Clean-up Calls affect the maturity of each CMO series. With its acquisition of senior living properties in May 2002, Capstead assumed $19 million in
fixed-rate mortgage financing from a commercial bank that matures in 2009 and $101 million in
tax-exempt bond debt. In November 2002, the tax-exempt bonds were refunded with proceeds from
issuing new 30-year adjustable-rate tax-exempt bonds. Under the terms of the Lease, changes in
interest rates on this debt are the responsibility of the lessee and as such, have a limited effect
on the Companys liquidity. In February 2004 the Company began selling common shares into the open market on a limited
basis, resulting in the issuance of 4,812,600 common shares by December 31, 2004. With these
sales, Capstead has raised $64.1 million of new common equity at an average price of $13.32 per
share, after expenses. These sales were highly accretive to the book value of existing
stockholders and may continue in 2005 if market conditions allow. EFFECTS OF INTEREST RATE CHANGES Interest Rate Sensitivity on Operating Results Capstead 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 financial assets and Derivatives held are included in this analysis. The sensitivity of
components of Other revenue (expense)to changes in interest rates is included as well, although no
asset sales are assumed. Because under the terms of the Lease the lessee is responsible for
changes in related debt service requirements, earnings from the Companys investment in net-leased
real estate are generally not affected by changes in interest rates. 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 investment premiums
and discounts. These assumptions are developed through a combination of historical analysis and
future expected pricing 42




---



##### 



Capstead Mortgage Corporation behavior. As of December 31, 2004 and 2003, the Company had the following estimated earnings
sensitivity profile (dollars in thousands): 10-year30-day
    
    
    U.S.LIBOR
    
    
    TreasuryRate
    
    
    Rate
    
    
    Immediate Change In:*30-day LIBOR rate
    
    
    
    
    
    
    
    
    
    Flat
    
    Up 1.00%
    
    Up 1.00%
    
    Up 2.00%10-year U.S. Treasury rate
    
    
    
    
    
    
    
    
    
    Down 1.00%
    
    Flat
    
    Up 1.00%
    
    Up 2.00%Projected 12-month
earnings change:December 31, 2004
    
    
    2.40
    %
    
    
    4.22
    %
    
    $
    (2,297
    )
    
    $
    (12,760
    )
    
    $
    (11,793
    )
    
    $
    (29,259
    )December 31, 2003
    
    
    1.12
    
    
    
    4.25
    
    
    
    (1,674
    )
    
    
    (10,732
    )
    
    
    (10,018
    )
    
    
    (21,713
    )
   *
    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 The increase in magnitude of projected earnings changes at December 31, 2004 compared to
the prior year-end reflects the increased size of Capsteads investment portfolios and increases in
short-term interest rates the latter half of 2004 not yet fully reflected in ARM securities yields
because the coupon interest rates on mortgage loans underlying these securities generally reset to
more current rates only once a year, subject to periodic and lifetime limits (see below). Income simulation modeling is the primary tool used by management to assess the direction and
magnitude of changes in net margins on financial 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 Capsteads earnings in various ways. Earnings currently
depend, in large part, on the difference between the interest received on mortgage securities and
similar investments, and the interest paid on related borrowings, which are generally based on
30-day LIBOR. The resulting financing spread may be reduced or even turn negative in a rising
short-term interest rate environment. Because the mortgage securities and similar investments
portfolio consists primarily of current-reset ARM securities, the effects of rising short-term
interest rates on borrowing costs can eventually be mitigated by increases in the rates of interest
earned on the underlying ARM loans, which generally reset periodically to a margin over a current
short-term interest rate index (typically a one-year index) subject to periodic and lifetime
limits, referred to as caps. Additionally, the Company extended maturities on a significant
portion of its borrowings during 2004, which effectively locked in attractive financing spreads on
the Companys modest position in fixed-rate and longer-to-reset ARM securities over the average
expected 43




---



##### 



Capstead Mortgage Corporation fixed-rate terms of these investments. As of December 31, 2004, the Companys ARM securities
featured the following average coupon rate, and average periodic and lifetime caps and average
months-to-roll (the average number of months to coupon reset date) (dollars in thousands): Average
    
    
    Average
    
    
    Average
    
    
    MonthsCoupon
    
    
    Periodic
    
    
    Lifetime
    
    
    ToARM Type
    
    Basis *
    
    
    Rate
    
    
    Cap
    
    
    Cap
    
    
    RollAgency
Securities:Fannie Mae/Freddie
Mac:Current-reset
    
    $
    1,526,808
    
    
    
    3.70
    %
    
    
    2.05
    %
    
    
    10.93
    %
    
    
    6.0Longer-to-reset
    
    
    629,218
    
    
    
    4.57
    
    
    
    3.90
    
    
    
    10.57
    
    
    
    25.0Ginnie Mae
    
    
    1,025,100
    
    
    
    3.87
    
    
    
    1.00
    
    
    
    9.99
    
    
    
    6.1Non-agency Securities
    
    
    56,261
    
    
    
    4.12
    
    
    
    1.72
    
    
    
    11.25
    
    
    
    5.5$
    3,237,387
    
    
    
    3.93
    
    
    
    2.07
    
    
    
    10.57
    
    
    
    9.7
   *
    Basis represents the Companys investment before unrealized gains and losses. Since only a portion of the ARM loans underlying these securities reset each month
subject to periodic and lifetime caps, interest rates on related 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, 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 would be adversely affected. To provide some protection to financing spreads
against rising interest rates, the Company may from time to time enter into longer-term repurchase
arrangements on a portion of its borrowings (as it did during 2004 on borrowings related to its
fixed-rate and longer-to-reset ARM securities) or invest in Derivatives such as interest rate swap
or cap agreements. At December 31, 2004, the Company did not own any Derivatives for this purpose. 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 securities and similar
investments generally increases. During periods of relatively low interest rates, prolonged
periods of high prepayments can significantly reduce the expected life of these investments;
therefore, the actual yields realized can be lower due to faster amortization of premiums.
Further, to the extent the proceeds of prepayments 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. Capstead periodically sells assets, which may increase income volatility because of the recognition
of transactional gains or losses. Such sales may become attractive as asset values fluctuate with
changes in interest rates. At other times, asset sales may become prudent to shift the Companys
investment focus. During periods of rising interest rates or contracting market liquidity, asset
values can decline, leading to increased margin calls and 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 44




---



##### 



Capstead Mortgage Corporation 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 affect 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 credit-sensitive 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 45




---



##### 



Capstead Mortgage Corporation 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. Similarly, junior liens and other forms of subordinated financing on single commercial
properties carry greater credit risk than senior lien financing, including a substantially greater
risk of non-payment of interest or principal. A decline in the value of the underlying real estate
could be large enough such that the aggregate outstanding balances of senior liens could exceed the
value of the real estate. In the event of default on a senior loan, the junior lienholder may need
to make payments on the senior loans in order to prevent foreclosure. Because the senior
lienholders generally have priority on proceeds from liquidating the underlying real estate, junior
lienholders may not recover all or any of their investment. To compensate for this heightened
credit risk, these loans generally earn substantially higher yields. 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. 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. RISKS ASSOCIATED WITH OWNING REAL ESTATE The direct ownership of commercial real estate involves a number of risks. With its
first acquisition of real estate, Capstead has attempted to mitigate these risks by entering into a
long-term net-lease arrangement whereby the lessee is responsible for the ongoing operation and
management of the properties and for paying all expenses associated with the operation of the
properties. Although reduced by this net-lease arrangement, risks of ownership remain, including:  
    The risk that changes in economic conditions or real estate markets may adversely affect the value of the properties.
    During inflationary periods, which are generally accompanied by rising interest rates, increases in operating costs and
borrowing rates may be greater than increases in lessee revenues from operating properties. Over an extended period of
time, this could result in lessee defaults.
    The risk that a deterioration of local conditions could adversely affect the ability of a lessee to profitably operate
a property. For instance, an oversupply of senior living properties could hamper the leasing of senior living units at
favorable rates. This could ultimately affect the value of the properties.
    Changes in tax, zoning or other laws could make properties less attractive or less profitable.
    An owner cannot be assured that lessees will elect to renew their leases when the terms
expire. If a lessee does not renew its lease or otherwise defaults on its lease obligations,
there is no assurance the owner can obtain a substitute lessee on acceptable terms. If the
owner cannot obtain another qualified operator to lease a property, the owner may be 46




---



##### 



Capstead Mortgage Corporation  required to modify the property for a different use, which may involve significant capital
expenditures and delays in re-leasing the property.
    The risk that lessees will not perform under their leases,
reducing the owners income from the leases or requiring the owner
to assume costs (such as real estate taxes, insurance, utilities
and maintenance) that are the lessees responsibility under
net-leases. In the case of special-purpose real estate such as
senior living facilities, compliance with licensing requirements
could complicate or delay the transfer of operational control of
such properties. This could lead to a significant cash flow
burden for the owner to service the debt and otherwise maintain
the properties.
    Net-leases generally require the lessee to carry comprehensive
liability, casualty, workers compensation and rental loss
insurance. The required coverage is typical of the type and
amount customarily obtained by an owner of similar properties.
However, there are some types of losses, such as catastrophic acts
of nature, for which insurance cannot be obtained at a
commercially reasonable cost. If there is an uninsured loss or a
loss in excess of insurance limits, the owner could lose both the
revenues generated by the affected property and the capital
invested in the property. The owner would, however, remain
obligated to repay any mortgage indebtedness or other obligations
related to the property.
    Investments in real estate are subject to various federal, state
and local regulatory requirements including the Americans with
Disabilities Act (the ADA). The ADA requires that public
accommodations reasonably accommodate individuals with
disabilities and that new construction or alterations be made to
commercial facilities to conform to accessibility guidelines.
Failure to comply with the ADA can result in injunctions, fines,
damage awards to private parties and additional capital
expenditures to remedy noncompliance. Existing requirements may
change and compliance with future requirements may involve
significant unanticipated expenditures. Typically these
expenditures would be the responsibility of the lessee under the
terms of net-leases; however, if lessees fail to perform these
obligations, the owner may be required to do so.
    Under federal, state and local environmental laws, the owner may
be required to investigate and clean up any release of hazardous
or toxic substances or petroleum products at its properties,
regardless of its knowledge or actual responsibility, simply
because of current or past ownership of the real estate. If
unidentified environmental problems arise, the owner may have to
make substantial payments, which could adversely affect cash flow
and the ability to make distributions to stockholders. This is
because:  1.
    The owner may have to pay for property damage and for investigation and clean-up
costs incurred in connection with the contamination.2.
    The law may impose clean-up responsibility and liability regardless of whether the
owner or operator knew of or caused the contamination. Even if more than one person is
responsible for the contamination, each person who shares legal liability under
environmental laws may be held responsible for all of the clean-up costs.3.
    Governmental entities and third parties may sue the owner or operator of a
contaminated site for damages and costs. 47




---



##### 



Capstead Mortgage Corporation    
    In investigating the acquisition of real estate, environmental
studies are typically performed to establish the existence of any
contamination. In addition, net-leases generally require lessees
to operate properties in compliance with environmental laws and to
indemnify the owner against environmental liability arising from
the operation of such properties.
    An owner may desire to sell a property in the future because of
changes in market conditions or poor lessee performance or to
avail itself of other opportunities. An owner may also be
required to sell a property to meet debt obligations or avoid a
default. Unlike investments in mortgage securities, real estate
cannot always be sold quickly, and there can be no assurance that
a property can be sold at a favorable price or that a prospective
buyer will view existing lease or operating arrangements
favorably. In addition, a property may require restoration or
modification before it is sold. REGULATORY MATTERS Tax Status As used herein, Capstead REIT refers to Capstead and the entities that are consolidated with
Capstead for federal income tax purposes. Capstead REIT has elected to be taxed as a REIT for
federal income tax purposes and intends to continue to do so. As a result of this election,
Capstead REIT will not be taxed at the corporate level on taxable income distributed to
stockholders, provided that certain requirements concerning the nature and composition of its
income and assets are met and that at least 90% of its REIT taxable income is distributed. If Capstead REIT were to fail to qualify as a REIT in any taxable year, it would be subject to
federal income tax at regular corporate rates and would not receive a deduction for dividends paid
to stockholders. If this were the case, the amount of after-tax income available for distribution
to stockholders would decrease substantially. As long as Capstead REIT qualifies as a REIT, it will
generally be taxable only on its undistributed taxable income. Distributions out of current or
accumulated taxable earnings and profits will be taxed to stockholders as ordinary income or
capital gain, as the case may be, and will not qualify for the dividend tax rate reduction to 15%
enacted as part of the Jobs and Growth Tax Relief Act of 2002, except as discussed below.
Distributions in excess of Capstead REITs current or accumulated earnings and profits will
constitute a non-taxable return of capital to the stockholders (except insofar as such
distributions exceed a stockholders cost basis of the shares of stock). Distributions by the
Company will not be eligible for the dividends received deduction for corporations. Should the
Company incur losses, stockholders will not be entitled to include such losses in their individual
income tax returns. Capstead may find it advantageous from time-to-time to elect taxable REIT subsidiary status
for certain of its subsidiaries. All taxable income of Capsteads taxable REIT subsidiaries, if
any, is subject to federal and state income taxes, where applicable. Capstead REITs taxable
income will include the income of its taxable REIT subsidiaries only upon distribution of such
income to Capstead REIT, and only if these distributions are made out of current or accumulated
earnings and profits of a taxable REIT subsidiary. Should this occur, a portion of Capsteads
distributions to its stockholders could qualify for the 15% dividend tax rate provided by the Jobs
and Growth Tax Relief Act of 2002. 48




---



##### 



Capstead Mortgage Corporation Investment Company Act of 1940 The Investment Company Act of 1940, as amended (the Investment Company Act), exempts from
regulation as an investment company any entity that is primarily engaged in the business of
purchasing or otherwise acquiring mortgages and other liens on, and interests in, real estate.
Capstead conducts its business so as not to become regulated as an investment company. If it were
to be regulated as an investment company, Capsteads ability to use leverage would be substantially
reduced and it would be unable to conduct its business as described herein. Under the current interpretation of the staff of the Securities and Exchange Commission
(SEC), in order to be exempted from regulation as an investment company, a REIT must, among other
things, maintain at least 55% of its assets directly in qualifying real estate interests. In
satisfying this 55% requirement, a REIT may treat mortgage-backed securities issued with respect to
an underlying pool to which it holds all issued certificates as qualifying real estate interests.
If the SEC or its staff adopts a contrary interpretation of such treatment, the REIT could be
required to sell a substantial amount of these securities or other non-qualified assets under
potentially adverse market conditions. 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 Premiums and Discounts on Financial Assets and Borrowings Premiums and
discounts on financial assets and borrowings are recognized in earnings as adjustments to
interest income or interest expense by the interest method over the estimated lives of the
related assets or borrowings. For most of Capsteads financial assets, estimates and
judgments related to future levels of mortgage prepayments are critical to this determination.
Mortgage prepayment expectations can vary considerably from period to period based on current
and projected changes in interest rates and other factors such as portfolio composition. For
instance, based on interest rate expectations as of January 27, 2005, management anticipates
an annualized lifetime runoff rate of 31% for its mortgage securities and similar investments
portfolio, up from 28% the previous year-end due largely to additions of newer-issue
securities during the year that tend to prepay faster than the Companys existing portfolio.
Should actual runoff rates differ materially from these estimates, the related $48 million in
premium on this portfolio would be expensed at a different pace. 49




---



##### 



Capstead Mortgage Corporation  
    Fair Value and Impairment Accounting for Financial Assets Most
of Capsteads mortgage securities and similar investments are
classified as held 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. As such, these unrealized gains and losses
enter into the calculation of book value per common share. Fair
values fluctuate with current and projected changes in interest
rates, prepayment expectations and other factors, such as market
liquidity. Considerable judgment is required interpreting market
data to develop estimated fair values, particularly in
circumstances of deteriorating credit quality and market liquidity
(see NOTE 10 to the accompanying consolidated financial
statements for discussion of how Capstead values its financial
assets). Generally, gains or losses are recognized in earnings
only if sold; however, if a decline in fair value of an individual
asset below its amortized cost occurs that is determined to be
other than temporary, the difference between amortized cost and
fair value would be included in Other revenue (expense)as an
impairment charge.
    Depreciation and Impairment Accounting for Real Estate held for
Lease Real estate is carried at cost, less accumulated
depreciation. Depreciation is provided using the straight-line
method over the estimated useful lives of buildings, equipment and
fixtures. If a significant adverse event or change in
circumstances occurs, management would assess if the values of the
Companys real estate properties have become impaired. If
estimated operating cash flows (undiscounted and without interest
charges) of a property over its remaining useful life are less
than its net carrying value, the difference between net carrying
value and fair value would be included in Other revenue (expense)
as an impairment charge. Considerable judgment is required in
determining useful lives of components of real estate properties
and in estimating operating cash flows, particularly during
periods of changing circumstances. 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.
Capstead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. Relative to the Companys investments in financial assets,
these factors may include, but are not limited to, changes in general economic conditions, the
availability of suitable investments from both an investment return and regulatory perspective,
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. Relative to direct investments in real estate, these
factors may include, but are not limited to, lessee performance under lease agreements, changes in
general as well as local economic conditions and real estate markets, increases in competition and
inflationary pressures, changes in the tax and regulatory environment including zoning and
environmental laws, uninsured losses or losses in excess of insurance limits and the availability
of adequate insurance coverage at reasonable costs. 50




---



##### 



Capstead Mortgage Corporation COMPARISON OF OPERATING INCOME
AND DILUTED INCOME PER COMMON SHARE The following table compares the calculation of operating income and operating income per
common share to net income and diluted net income per common share (in thousands, except per share
amounts): Year Ended December 312004
    
    
    2003
    
    
    2002Operating
    
    
    Diluted
    
    
    Operating
    
    
    Diluted
    
    
    Operating
    
    
    DilutedNet income
    
    $
    41,805
    
    
    $
    41,805
    
    
    $
    60,659
    
    
    $
    60,659
    
    
    $
    96,123
    
    
    $
    96,123Adjustments for:Depreciation on real estate
    
    
    3,708
    
    
    
    
    
    
    
    3,708
    
    
    
    
    
    
    
    2,543
    
    
    
    Gain on asset sales
    
    
    
    
    
    
    
    
    
    
    (4,560
    )
    
    
    
    
    
    
    (4,725
    )
    
    
    Series B preferred dividends
    
    
    (19,932
    )
    
    
    (19,932
    )
    
    
    (19,931
    )
    
    
    
    
    
    
    (19,954
    )
    
    
    $
    25,581
    
    
    $
    21,873
    
    
    $
    39,876
    
    
    $
    60,659
    
    
    $
    73,987
    
    
    $
    96,123Weighted average common
shares outstanding
    
    
    16,100
    
    
    
    16,100
    
    
    
    13,977
    
    
    
    13,977
    
    
    
    13,858
    
    
    
    13,858Net effect of dilutive
securities:Stock options
    
    
    29
    
    
    
    29
    
    
    
    35
    
    
    
    35
    
    
    
    57
    
    
    
    57Preferred A
    
    
    308
    
    
    
    308
    
    
    
    315
    
    
    
    315
    
    
    
    260
    
    
    
    260Preferred B shares
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    8,968
    
    
    
    
    
    
    
    5,65216,437
    
    
    
    16,437
    
    
    
    14,327
    
    
    
    23,295
    
    
    
    14,175
    
    
    
    19,827Per common share
    
    $
    1.56
    
    
    $
    1.33
    
    
    $
    2.78
    
    
    $
    2.60
    
    
    $
    5.22
    
    
    $
    4.85
 51