##### Table of Contents



UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 FORM 10-Q  þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR
15(d)OF
THE SECURITIES EXCHANGE ACT OF 1934For the quarterly period ended: June 30, 2004ORo
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR
15(d)OF
THE SECURITIES EXCHANGE ACT OF 1934For the transition period from ______ to ______ Commission File Number: 1-8996 CAPSTEAD MORTGAGE CORPORATION  Maryland
(State or other jurisdiction of
incorporation or organization)
    
    75-2027937
(I.R.S. Employer
Identification No.)
 8401 North Central Expressway, Suite 800, Dallas, TX
(Address of principal executive offices)
    
    75225
(Zip Code)
 Registrants telephone number, including area code: (214) 874-2323 Indicate by check mark whether the Registrant (1) has filed all documents and
reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
YES  þ     NO  o Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
YES  þ     NO  o APPLICABLE ONLY TO CORPORATE ISSUERS: Indicate the number of shares outstanding of each of the issuers classes of
common stock, as of the last practicable date. Common Stock ($0.01 par value)
    
    16,319,480 as of August 6, 2004




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CAPSTEAD MORTGAGE CORPORATION
FORM 10-Q
FOR THE QUARTER ENDED JUNE 30, 2004 INDEX PagePART I.  FINANCIAL INFORMATIONITEM 1.
    
    Financial StatementsConsolidated Balance Sheets  June 30, 2004 and December 31, 2003
    
    
    3Consolidated Statements of Operations  Quarter and Six Months Ended
June 30, 2004 and 2003
    
    
    4Consolidated Statements of Cash Flows  Six Months Ended June 30, 2004 and 2003
    
    
    5Notes to Consolidated Financial Statements
    
    
    6ITEM 2.
    
    Managements Discussion and Analysis of
Financial Condition and Results of Operations
    
    
    16ITEM 3.
    
    Qualitative and Quantitative Disclosure of Market Risk
    
    
    33ITEM 4.
    
    Controls and Procedures
    
    
    33PART II.  OTHER INFORMATIONITEM 6.
    
    Exhibits and Reports on Form 8-K
    
    
    33SIGNATURES
    
    
    34Computation of Ratio of Earnings to Combined Fixed Charges and Preferred Stock DividendsCertification Pursuant to Section 302Certification Pursuant to Section 302Certification Pursuant to Section 906
  -2-




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ITEM 1. FINANCIAL STATEMENTS 
 PART I.  FINANCIAL INFORMATION 
 CAPSTEAD MORTGAGE CORPORATION
CONSOLIDATED BALANCE SHEETS (In thousands, except per share amounts)
 June 30, 2004
    
    December 31, 2003(unaudited)
    
    (NOTE 2)AssetsMortgage
securities and similar investments
($2.4 billion pledged under repurchase arrangements in 2004)
    
    $
    2,612,662
    
    
    $
    2,195,117CMO collateral and investments
    
    
    105,311
    
    
    
    167,5712,717,973
    
    
    
    2,362,688Real estate held for lease, net of accumulated depreciation
    
    
    131,559
    
    
    
    133,414Receivables and other assets
    
    
    44,917
    
    
    
    41,880Cash and cash equivalents
    
    
    23,180
    
    
    
    16,340$
    2,917,629
    
    
    $
    2,554,322LiabilitiesRepurchase arrangements and similar borrowings
    
    $
    2,386,071
    
    
    $
    1,975,178Collateralized mortgage obligations (CMOs)
    
    
    104,675
    
    
    
    166,807Borrowings secured by real estate
    
    
    120,101
    
    
    
    120,206Common stock dividend payable
    
    
    7,994
    
    
    
    8,829Accounts payable and accrued expenses
    
    
    4,841
    
    
    
    6,2642,623,682
    
    
    
    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
June 30, 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
June 30, 2004 and December 31, 2003
($180,025 aggregate liquidation preference)
    
    
    176,707
    
    
    
    176,707Common stock
 $0.01 par value; 100,000 shares authorized;
16,074 and 14,015 shares issued and outstanding at
June 30, 2004 and December 31, 2003, respectively
    
    
    161
    
    
    
    140Paid-in capital
    
    
    484,919
    
    
    
    456,198Accumulated deficit
    
    
    (387,718
    )
    
    
    (387,718
    )Accumulated other comprehensive income
    
    
    17,051
    
    
    
    28,755293,947
    
    
    
    277,038$
    2,917,629
    
    
    $
    2,554,322
 See accompanying notes to consolidated financial statements. -3-




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CAPSTEAD MORTGAGE CORPORATION 
 CONSOLIDATED STATEMENTS OF OPERATIONS
 (In thousands, except per share amounts)
(Unaudited)
 Quarter Ended
    
    Six Months EndedJune 30
    
    June 302004
    
    2003
    
    2004
    
    2003Interest income:Mortgage securities and similar investments
    
    $
    19,279
    
    
    $
    21,648
    
    
    $
    38,716
    
    
    $
    46,785CMO collateral and investments
    
    
    1,866
    
    
    
    10,122
    
    
    
    4,372
    
    
    
    25,090Total interest income
    
    
    21,145
    
    
    
    31,770
    
    
    
    43,088
    
    
    
    71,875Interest and related expense:Repurchase arrangements and similar borrowings
    
    
    6,967
    
    
    
    6,454
    
    
    
    12,797
    
    
    
    13,673CMO borrowings
    
    
    1,659
    
    
    
    10,010
    
    
    
    3,952
    
    
    
    25,349Mortgage insurance and other
    
    
    67
    
    
    
    99
    
    
    
    114
    
    
    
    208Total interest and related expense
    
    
    8,693
    
    
    
    16,563
    
    
    
    16,863
    
    
    
    39,230Net margin on financial assets
    
    
    12,452
    
    
    
    15,207
    
    
    
    26,225
    
    
    
    32,645Real estate lease income
    
    
    2,434
    
    
    
    2,575
    
    
    
    4,959
    
    
    
    5,096Real estate-related expense:Interest
    
    
    1,061
    
    
    
    1,133
    
    
    
    2,146
    
    
    
    2,225Depreciation
    
    
    927
    
    
    
    927
    
    
    
    1,854
    
    
    
    1,854Total real estate-related expense
    
    
    1,988
    
    
    
    2,060
    
    
    
    4,000
    
    
    
    4,079Net margin on real estate held for lease
    
    
    446
    
    
    
    515
    
    
    
    959
    
    
    
    1,017Other revenue (expense):Gain on asset sales and CMO redemptions
    
    
    
    
    
    
    1,392
    
    
    
    
    
    
    
    3,140CMO administration and other
    
    
    249
    
    
    
    181
    
    
    
    316
    
    
    
    401Incentive fee payable to former affiliate
    
    
    
    
    
    
    (197
    )
    
    
    
    
    
    
    (500
    )Other operating expense
    
    
    (1,332
    )
    
    
    (1,857
    )
    
    
    (3,331
    )
    
    
    (3,919
    )Total other revenue (expense)
    
    
    (1,083
    )
    
    
    (481
    )
    
    
    (3,015
    )
    
    
    (878
    )Net income
    
    $
    11,815
    
    
    $
    15,241
    
    
    $
    24,169
    
    
    $
    32,784Net income
    
    $
    11,815
    
    
    $
    15,241
    
    
    $
    24,169
    
    
    $
    32,784Less cash dividends paid on preferred shares
    
    
    (5,064
    )
    
    
    (5,068
    )
    
    
    (10,131
    )
    
    
    (10,138
    )Net income available to common stockholders
    
    $
    6,751
    
    
    $
    10,173
    
    
    $
    14,038
    
    
    $
    22,646Net income per common share:Basic
    
    $
    0.44
    
    
    $
    0.73
    
    
    $
    0.95
    
    
    $
    1.62Diluted
    
    
    0.44
    
    
    
    0.65
    
    
    
    0.94
    
    
    
    1.41Cash dividends declared per share:Common
    
    $
    0.500
    
    
    $
    0.780
    
    
    $
    1.030
    
    
    $
    1.720Series A Preferred
    
    
    0.400
    
    
    
    0.400
    
    
    
    0.800
    
    
    
    0.800Series B Preferred
    
    
    0.315
    
    
    
    0.315
    
    
    
    0.630
    
    
    
    0.630
 See accompanying notes to consolidated financial statements. -4-




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CAPSTEAD MORTGAGE CORPORATION 
 CONSOLIDATED STATEMENTS OF CASH FLOWS
 (In thousands)
(Unaudited)
 Six Months EndedJune 302004
    
    2003Operating activities:Net income
    
    $
    24,169
    
    
    $
    32,784Noncash items:Amortization of discount and premium
    
    
    5,510
    
    
    
    6,750Depreciation and other amortization
    
    
    2,217
    
    
    
    2,542Recognition of rent abatement
    
    
    85
    
    
    
    16Gain on asset sales and CMO redemptions
    
    
    
    
    
    
    (3,140
    )Change in incentive fee payable to former affiliate
    
    
    
    
    
    
    (4,482
    )Net change in receivables, other assets,
accounts payable and accrued expenses
    
    
    (2,942
    )
    
    
    (16,139
    )Net cash provided by operating activities
    
    
    29,039
    
    
    
    18,331Investing activities:Purchases of mortgage securities and similar investments
    
    
    (787,353
    )
    
    
    (50,748
    )Principal collections on mortgage securities
and similar investments
    
    
    350,408
    
    
    
    429,427Proceeds from asset sales
    
    
    
    
    
    
    76,055CMO collateral:Principal collections
    
    
    61,358
    
    
    
    463,782Decrease in accrued interest receivable
    
    
    392
    
    
    
    3,129Net cash provided by (used in) investing activities
    
    
    (375,195
    )
    
    
    921,645Financing activities:Net increase (decrease) in repurchase arrangements
and similar borrowings
    
    
    410,893
    
    
    
    (264,025
    )Principal payments on borrowings secured by real estate
    
    
    (105
    )
    
    
    (101
    )CMO borrowings:Principal payments on securities
    
    
    (60,975
    )
    
    
    (532,030
    )Decrease in accrued interest payable
    
    
    (364
    )
    
    
    (2,817
    )Capital stock transactions
    
    
    30,314
    
    
    
    70Dividends paid
    
    
    (26,767
    )
    
    
    (139,855
    )Net cash provided by (used in) financing activities
    
    
    352,996
    
    
    
    (938,758
    )Net change in cash and cash equivalents
    
    
    6,840
    
    
    
    1,218Cash and cash equivalents at beginning of period
    
    
    16,340
    
    
    
    59,003Cash and cash equivalents at end of period
    
    $
    23,180
    
    
    $
    60,221
 See accompanying notes to consolidated financial statements. -5-




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CAPSTEAD MORTGAGE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2004
(Unaudited) NOTE 1  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, financial assets, specifically residential 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
that 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, the relationship between
short- and long-term interest rates (the yield curve) and the extent the
Company continues to invest its liquidity in these portfolios. Although the
Company has had success in recent quarters acquiring ARM securities at
relatively attractive prices and runoff caused by mortgage prepayments has
moderated from levels experienced in 2003, replacing investments lost to runoff
remains a challenge to earnings generated by these portfolios. To the extent
the proceeds of mortgage prepayments and other maturities are not reinvested or
cannot be reinvested at rates of return on invested capital at least equal to
the returns earned on previous investments, earnings and common dividends will
likely decline. NOTE 2  BASIS OF PRESENTATION Interim Financial Reporting The accompanying unaudited consolidated financial statements have been prepared
in accordance with accounting principles generally accepted in the United
States (GAAP) for interim financial information and with the instructions to
Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include
all of the information and footnotes required by GAAP for complete financial
statements. In the opinion of management, all adjustments (consisting of
normal recurring accruals) considered necessary for a fair presentation have
been included. Operating results for the quarter and six months ended June 30,
2004 are not necessarily indicative of the results that may be expected for the
calendar year ending December 31, 2004. For further information refer to the
consolidated financial statements and footnotes thereto incorporated by
reference in the Companys annual report on Form 10-K for the year ended
December 31, 2003. Stock-Based Compensation The Company 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 the 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. The
increase in total stock-based compensation expense if determined under the fair
value-based methodology prescribed under Statement of Financial Accounting
Standards No. 123 Accounting for - 6 -




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Stock-based Compensation (SFAS 123) would have been less than $10,000 for
the quarter and six months ended June 30, 2004 and 2003, respectively, which
would have had no effect on reported net income per common share for the
periods presented. NOTE 3  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. The components of the
computation of basic and diluted net income per share were as follows (in
thousands, except per share data): Quarter Ended June 30
    
    Six Months Ended June 302004
    
    2003
    
    2004
    
    2003Numerator for basic net income per common share:Net income
    
    $
    11,815
    
    
    $
    15,241
    
    
    $
    24,169
    
    
    $
    32,784Less all preferred share dividends
    
    
    (5,064
    )
    
    
    (5,068
    )
    
    
    (10,131
    )
    
    
    (10,138
    )Net income available to common stockholders
    
    $
    6,751
    
    
    $
    10,173
    
    
    $
    14,038
    
    
    $
    22,646Weighted average common shares outstanding
    
    
    15,237
    
    
    
    13,978
    
    
    
    14,752
    
    
    
    13,957Basic net income per common share
    
    $
    0.44
    
    
    $
    0.73
    
    
    $
    0.95
    
    
    $
    1.62Numerator for diluted net income per common share:Net income
    
    $
    11,815
    
    
    $
    15,241
    
    
    $
    24,169
    
    
    $
    32,784Less dividends on Series B preferred shares
    
    
    (4,983
    )
    
    
    
    
    
    
    (9,966
    )
    
    
    $
    6,832
    
    
    $
    15,241
    
    
    $
    14,203
    
    
    $
    32,784Denominator for diluted net income per common
share:Weighted average common shares outstanding
    
    
    15,237
    
    
    
    13,978
    
    
    
    14,752
    
    
    
    13,957Net effect of dilutive stock options
    
    
    30
    
    
    
    35
    
    
    
    35
    
    
    
    41Net effect of dilutive preferred shares:Series A
    
    
    311
    
    
    
    314
    
    
    
    313
    
    
    
    316Series B
    
    
    
    
    
    
    8,943
    
    
    
    
    
    
    
    8,92615,578
    
    
    
    23,270
    
    
    
    15,100
    
    
    
    23,240Diluted net income per common share
    
    $
    0.44
    
    
    $
    0.65
    
    
    $
    0.94
    
    
    $
    1.41
 NOTE 4  MORTGAGE SECURITIES AND SIMILAR INVESTMENTS The Company classifies its mortgage securities and similar investments 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 June 30, 2004 are $6.0 million in
related special hazard (e.g. earthquake or mudslide-related losses) and
bankruptcy reserve funds. 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 June 30, 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. - 7 -




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Fixed-rate investments have fixed rates of interest and initial expected
weighted average lives of greater than five years. Adjustable-rate investments
generally have interest rates that adjust at least annually to more current
interest rates. For instance, mortgage loans underlying ARM securities either
(i) adjust annually based on a specified margin over the one-year Constant
Maturity U.S. Treasury Note Rate (One-year CMT), (ii) adjust semiannually
based on a specified margin over the six-month London Interbank Offered Rate
(LIBOR), or (iii) adjust monthly based on a specific margin over an index
such as LIBOR or the Cost of Funds Index as published by the Eleventh District
Federal Reserve Bank (COFI), 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. CMBS held as of June 30, 2004 adjust monthly
based on a specified margin over 30-day LIBOR. Mortgage securities and similar
investments and the related average effective interest rates were as follows
(dollars in thousands): Average
    
    AveragePrincipal
    
    Premiums
    
    
    
    
    
    Carrying
    
    Coupon
    
    EffectiveBalance
    
    (Discounts)
    
    Basis
    
    Amount (a)
    
    Rate (b)
    
    Rate(b)June 30, 2004Agency Securities:Fannie Mae/Freddie Mac:Fixed-rate
    
    $
    46,010
    
    
    $
    196
    
    
    $
    46,206
    
    
    $
    46,273
    
    
    
    6.65
    %
    
    
    5.98
    %LIBOR/CMT ARMs
    
    
    1,274,071
    
    
    
    22,410
    
    
    
    1,296,481
    
    
    
    1,310,854
    
    
    
    3.51
    
    
    
    2.79COFI ARMs
    
    
    78,045
    
    
    
    (2,257
    )
    
    
    75,788
    
    
    
    78,713
    
    
    
    3.48
    
    
    
    4.49Ginnie Mae ARMs
    
    
    985,198
    
    
    
    10,033
    
    
    
    995,231
    
    
    
    993,768
    
    
    
    4.05
    
    
    
    3.172,383,324
    
    
    
    30,382
    
    
    
    2,413,706
    
    
    
    2,429,608
    
    
    
    3.80
    
    
    
    3.07Non-agency Securities:Fixed-rate
    
    
    42,298
    
    
    
    54
    
    
    
    42,352
    
    
    
    42,431
    
    
    
    6.78
    
    
    
    6.19LIBOR/CMT ARMs
    
    
    65,993
    
    
    
    906
    
    
    
    66,899
    
    
    
    67,553
    
    
    
    3.93
    
    
    
    3.20108,291
    
    
    
    960
    
    
    
    109,251
    
    
    
    109,984
    
    
    
    5.04
    
    
    
    4.37CMBS
    
    
    73,069
    
    
    
    3
    
    
    
    73,072
    
    
    
    73,070
    
    
    
    2.24
    
    
    
    2.19$
    2,564,684
    
    
    $
    31,345
    
    
    $
    2,596,029
    
    
    $
    2,612,662
    
    
    
    3.80
    
    
    
    3.10December 31, 2003Agency Securities:Fannie Mae/Freddie Mac:Fixed-rate
    
    $
    2,072
    
    
    $
    12
    
    
    $
    2,084
    
    
    $
    2,160
    
    
    
    10.00
    %
    
    
    9.38
    %LIBOR/CMT ARMs
    
    
    1,050,761
    
    
    
    15,626
    
    
    
    1,066,387
    
    
    
    1,084,492
    
    
    
    3.67
    
    
    
    3.60COFI ARMs
    
    
    90,669
    
    
    
    (2,623
    )
    
    
    88,046
    
    
    
    91,566
    
    
    
    3.57
    
    
    
    4.84Ginnie 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
    
    
    
    6.25LIBOR/CMT ARMs
    
    
    81,425
    
    
    
    1,293
    
    
    
    82,718
    
    
    
    83,724
    
    
    
    4.42
    
    
    
    3.64200,063
    
    
    
    1,467
    
    
    
    201,530
    
    
    
    202,536
    
    
    
    5.75
    
    
    
    4.63CMBS
    
    
    74,376
    
    
    
    (9
    )
    
    
    74,367
    
    
    
    74,376
    
    
    
    2.21
    
    
    
    2.83Commercial loans
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    8.40$
    2,144,817
    
    
    $
    22,303
    
    
    $
    2,167,120
    
    
    $
    2,195,117
    
    
    
    4.02
    
    
    
    3.97
   (a)
    
    Includes unrealized gains and losses 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 quarter then ended, calculated including the amortization of
mortgage insurance costs on Non-agency Securities and investment premiums
(discounts) and excluding unrealized gains and losses. - 8 -




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##### Table of Contents



NOTE 5  CMO COLLATERAL AND INVESTMENTS CMO collateral consists of Non-agency Securities and related accrued interest,
pledged to secure CMO borrowings (Pledged CMO Collateral). All principal and
interest on Non-agency Securities is remitted directly to collection accounts
maintained by a trustee and is available for the payment of principal and
interest on CMO borrowings. The components of CMO collateral and investments
were as follows (in thousands): June 30, 2004
    
    December 31, 2003Pledged CMO Collateral:Pledged Non-agency Securities
    
    $
    103,448
    
    
    $
    164,891Accrued interest receivable
    
    
    697
    
    
    
    1,085104,145
    
    
    
    165,976Unamortized premium
    
    
    1,166
    
    
    
    1,595$
    105,311
    
    
    $
    167,571
 Credit risk associated with Pledged CMO Collateral is borne by AAA-rated
private mortgage insurers or subordinated bonds within the related CMO series
to which the collateral is pledged. The weighted average yield for Pledged CMO
Collateral and investments was 6.46% during the quarter ended June 30, 2004. NOTE 6  REAL ESTATE HELD FOR LEASE In May 2002 Capstead acquired six independent senior living facilities
(wherein the operator of the facility provides most of the 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 Investment Group, LLC
which, together with its affiliates, is referred to as Fortress. Until July
2003 Fortress was affiliated with the Company (see NOTE 14). 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. After an initial three-month rent
concession period, 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. Because under the
terms of the Lease, Brookdale is responsible for changes in related debt
service requirements, earnings from this investment are generally not affected
by changes in interest rates. Included in Receivables and other assetsat June
30, 2004 are $3.0 million in unamortized rent abatements and $1.2 million of
other rent receivables due from Brookdale. - 9 -




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##### Table of Contents



Carrying amounts of the Properties were as follows (in thousands): June 30, 2004
    
    December 31, 2003Land
    
    $
    16,450
    
    
    $
    16,450Buildings
    
    
    119,550
    
    
    
    119,550Equipment and fixtures
    
    
    3,600
    
    
    
    3,600139,600
    
    
    
    139,600Accumulated depreciation
    
    
    (8,041
    )
    
    
    (6,186
    )$
    131,559
    
    
    $
    133,414
 NOTE 7  REPURCHASE ARRANGEMENTS AND SIMILAR BORROWINGS Capstead borrows under uncommitted repurchase arrangements with only
well-established investment banking firms. Repurchase arrangements pursuant to
which the Company pledges Agency and Non-agency Securities as collateral
generally have maturities of less than 31 days, although during the second
quarter of 2004 the Company extended maturities for up to two years on $308
million of its borrowings related to the Companys modest position in
fixed-rate securities and certain longer-to-reset ARM securities. Repurchase
arrangements with CMBS pledged as collateral generally have longer initial
maturities and may feature renewal options. The terms and conditions of
repurchase arrangements and similar borrowings are negotiated on a
transaction-by-transaction basis. Repurchase arrangements and similar
borrowings and related weighted average interest rates, classified by type of
collateral and maturities, were as follows for the dates indicated (dollars in
thousands): June 30, 2004
    
    December 31, 2003Borrowings
    
    Average
    
    Borrowings
    
    AverageOutstanding
    
    Rate
    
    Outstanding
    
    RateRepurchase arrangements:Agency Securities (less than 31 days)
    
    $
    1,923,031
    
    
    
    1.19
    %
    
    $
    1,735,027
    
    
    
    1.09
    %Agency Securities (greater than 1 year)
    
    
    308,463
    
    
    
    2.20
    
    
    
    
    
    
    
    Non-agency Securities (less than 31 days)
    
    
    85,937
    
    
    
    1.69
    
    
    
    170,205
    
    
    
    1.57CMBS (less than 31 days)
    
    
    20,300
    
    
    
    1.44
    
    
    
    20,300
    
    
    
    1.36CMBS (greater than 90 days)
    
    
    48,340
    
    
    
    1.35
    
    
    
    49,646
    
    
    
    1.34$
    2,386,071
    
    
    
    1.34
    
    
    $
    1,975,178
    
    
    
    1.14
 NOTE 8  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 (dollars in thousands): June 30, 2004
    
    December 31, 2003CMOs
    
    $
    103,030
    
    
    $
    164,388Accrued interest payable
    
    
    574
    
    
    
    938Total obligation
    
    
    103,604
    
    
    
    165,326Unamortized premium
    
    
    1,071
    
    
    
    1,481$
    104,675
    
    
    $
    166,807Range of average interest rates
    
    1.66% to 9.51%
    
    1.50% to 9.42%Range of stated maturities
    
    
    2025 to 2030
    
    
    
    2025 to 2030Number of series
    
    
    6
    
    
    
    6
 - 10 -




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##### Table of Contents



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 Pledged CMO Collateral. Each series is
also subject to redemption provided that certain requirements specified in the
related indenture have been met (referred to as Clean-up Calls); therefore,
the actual maturity of any series is likely to occur earlier than its stated
maturity. The weighted average effective interest rate for all CMOs was 5.74%
during the quarter ended June 30, 2004. NOTE 9  BORROWINGS SECURED BY REAL ESTATE The components of borrowings secured by real estate and related weighted
average interest rates (calculated including bond issue cost amortization) for
the dates indicated were as follows (dollars in thousands): June 30, 2004
    
    December 31, 2003Borrowings
    
    Average
    
    Borrowings
    
    AverageOutstanding
    
    Rate
    
    Outstanding
    
    RateMortgage borrowings
    
    $
    19,260
    
    
    
    7.92
    %
    
    $
    19,365
    
    
    
    7.92
    %Tax-exempt bonds
    
    
    100,841
    
    
    
    2.84
    
    
    
    100,841
    
    
    
    2.54$
    120,101
    
    
    
    3.65
    
    
    $
    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, 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. The interest rate cap
agreements were valued at $139,000 at June 30, 2004 and included in Receivables
and other assets.Monthly principal and interest rate cap reserve fund
payments are made to the trustee for the eventual retirement of the bonds by
2032 and the purchase of new cap agreements in 2007. In connection with the issuance of new tax-exempt bonds in November 2002,
Capstead placed into escrow with the trustee reserves for repairs and
replacements totaling $2.9 million. During 2003, the trustee released $1.5
million of these funds. Another $6.1 million is held by the trustee in
connection with Capstead posting a $6.0 million letter of credit from a rated
financial institution to collateralize certain of the bonds. These funds,
along with $2.0 million of principal and interest rate cap reserve funds, are
included in Receivables and other assetsas restricted cash. Also included in
Receivables and other assetsare $3.0 million in bond issue costs. The weighted average effective interest rate for all borrowings secured by real
estate (calculated including bond issue cost amortization) was 3.54% for the
quarter ended June 30, 2004. NOTE 10  DISCLOSURES REGARDING FAIR VALUES OF DEBT SECURITIES Estimated fair values of debt securities were determined using available market
information and appropriate valuation methodologies; however, considerable
judgment is required in interpreting market data to develop these estimates.
In addition, fair values fluctuate on a daily basis. Accordingly, estimates
presented herein are not necessarily indicative of the amounts that could be
realized in a current market exchange. The use of different market assumptions
and/or estimation methodologies may have a material effect on estimated fair
values. The fair value of Agency Securities, Non-agency Securities and CMBS -11-




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##### Table of Contents



were estimated using either (i) quoted market prices when available, including
quotes made by lenders in connection with designating collateral for repurchase
arrangements, or (ii) offer prices for similar assets or market positions. The
fair value of Pledged CMO Collateral was based on projected cash flows, after
payment on the related CMOs, determined using market discount rates and
prepayment assumptions. The maturity of mortgage assets is directly affected by
the rate of principal payments on the underlying mortgage loans and, for
Pledged CMO Collateral, Clean-up Calls of the remaining CMOs outstanding.
Investments not held in the form of debt or equity securities are excluded from
these disclosures. Fair value disclosures for available-for-sale debt securities were as follows
(in thousands): Gross
    
    GrossCost
    
    Unrealized
    
    Unrealized
    
    FairBasis
    
    Gains
    
    Losses
    
    ValueAs of June 30, 2004Agency Securities:Fixed-rate
    
    $
    743
    
    
    $
    67
    
    
    $
    
    
    
    $
    810ARMs
    
    
    2,367,500
    
    
    
    20,020
    
    
    
    4,185
    
    
    
    2,383,3352,368,243
    
    
    
    20,087
    
    
    
    4,185
    
    
    
    2,384,145Non-agency Securities:Fixed-rate
    
    
    1,061
    
    
    
    79
    
    
    
    
    
    
    
    1,140ARMs
    
    
    48,653
    
    
    
    668
    
    
    
    14
    
    
    
    49,30749,714
    
    
    
    747
    
    
    
    14
    
    
    
    50,447CMBS
    
    
    73,072
    
    
    
    10
    
    
    
    12
    
    
    
    73,070CMO collateral and investments
    
    
    13,312
    
    
    
    418
    
    
    
    
    
    
    
    13,730$
    2,504,341
    
    
    $
    21,262
    
    
    $
    4,211
    
    
    $
    2,521,392As 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 and investments
    
    
    16,440
    
    
    
    499
    
    
    
    
    
    
    
    16,939$
    2,039,386
    
    
    $
    28,767
    
    
    $
    271
    
    
    $
    2,067,882
 Held-to-maturity debt securities consist of Pledged CMO Collateral and
collateral released from the related CMO indentures pursuant to Clean-up Calls
and held as Agency Securities and Non-agency Securities. Fair value
disclosures for held-to-maturity debt securities were as follows (in
thousands): Gross
    
    GrossCost
    
    Unrealized
    
    Unrealized
    
    FairBasis
    
    Gains
    
    Losses
    
    ValueAs of June 30, 2004Released CMO Collateral:Agency Securities  fixed-rate
    
    $
    45,463
    
    
    $
    2,051
    
    
    $
    
    
    
    $
    47,514Non-agency Securities:Fixed-rate
    
    
    41,291
    
    
    
    1,330
    
    
    
    
    
    
    
    42,621ARMs
    
    
    18,246
    
    
    
    106
    
    
    
    219
    
    
    
    18,133105,000
    
    
    
    3,487
    
    
    
    219
    
    
    
    108,268Pledged CMO Collateral
    
    
    91,581
    
    
    
    186
    
    
    
    
    
    
    
    91,767$
    196,581
    
    
    $
    3,673
    
    
    $
    219
    
    
    $
    200,035
 -12-




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##### Table of Contents



Gross
    
    GrossCost
    
    Unrealized
    
    Unrealized
    
    FairBasis
    
    Gains
    
    Losses
    
    ValueAs of December 31, 2003Released CMO Collateral:Agency Securities  fixed-rate
    
    $
    1,257
    
    
    $
    113
    
    
    $
    
    
    
    $
    1,370Non-agency SecuritiesFixed-rate
    
    
    118,812
    
    
    
    4,310
    
    
    
    
    
    
    
    123,122ARMs
    
    
    24,105
    
    
    
    135
    
    
    
    365
    
    
    
    23,875144,174
    
    
    
    4,558
    
    
    
    365
    
    
    
    148,367Pledged CMO Collateral
    
    
    150,632
    
    
    
    224
    
    
    
    
    
    
    
    150,856$
    294,806
    
    
    $
    4,782
    
    
    $
    365
    
    
    $
    299,223
 Sales of released CMO collateral classified as held-to-maturity occasionally
occur provided the collateral has paid down to within 10% of its original
issuance amounts. Dispositions of debt securities were as follows (in
thousands): Quarter Ended June 30
    
    Six Months Ended June 302004
    
    2003
    
    2004
    
    2003Sale of securities held available-for-sale:Amortized cost
    
    $
    
    
    
    $
    22,208
    
    
    $
    
    
    
    $
    50,748Gain
    
    
    
    
    
    
    818
    
    
    
    
    
    
    
    1,831Sale of released CMO collateral
held-to-maturity:Amortized cost
    
    
    
    
    
    
    18,763
    
    
    
    
    
    
    
    22,770Gain
    
    
    
    
    
    
    681
    
    
    
    
    
    
    
    810
 NOTE 11  COMPREHENSIVE INCOME (LOSS) Comprehensive income (loss) is net income plus other comprehensive loss, which,
for the periods presented, consists primarily of the change in unrealized gain
on debt securities classified as available-for-sale. The following table
provides information regarding comprehensive income (loss) (in thousands): Quarter Ended
    
    Six Months EndedJune 30
    
    June 302004
    
    2003
    
    2004
    
    2003Net income
    
    $
    11,815
    
    
    $
    15,241
    
    
    $
    24,169
    
    
    $
    32,784Other comprehensive income (loss):Unrealized gain on Derivatives
held as cash flow hedges:Change in unrealized gain during period
    
    
    (50
    )
    
    
    (224
    )
    
    
    (178
    )
    
    
    (269
    )Reclassification adjustment for amounts
included in net income
    
    
    (30
    )
    
    
    (10
    )
    
    
    (81
    )
    
    
    (37
    )(80
    )
    
    
    (234
    )
    
    
    (259
    )
    
    
    (306
    )Unrealized gain on debt securities:Change in unrealized gain during period
    
    
    (14,117
    )
    
    
    (1,746
    )
    
    
    (11,445
    )
    
    
    (1,938
    )Reclassification adjustment for gain
included in net income
    
    
    
    
    
    
    (818
    )
    
    
    
    
    
    
    (1,831
    )Other comprehensive loss
    
    
    (14,197
    )
    
    
    (2,798
    )
    
    
    (11,704
    )
    
    
    (4,075
    )Comprehensive income (loss)
    
    $
    (2,382
    )
    
    $
    12,443
    
    
    $
    12,465
    
    
    $
    28,709
 -13-




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##### Table of Contents



NOTE 12  RESULTS OF CAPITAL RAISING ACTIVITY Between February 2 and June 30, 2004, the Company sold 2,019,400 common shares
into the open market on a limited basis and such sales resumed during the third
quarter. As of quarter-end, Capstead raised nearly $30 million of new common
equity with these sales at an average price of $14.80 per share, after
expenses. The proceeds from these issuances have been invested in
attractively-priced ARM securities. NOTE 13  NET INTEREST INCOME ANALYSIS The following tables summarize interest income and interest expense and
weighted average interest rates pertaining to the Companys investments in
financial assets (excludes investments in real estate and related borrowings)
(dollars in thousands): Quarter Ended June 302004
    
    2003Average
    
    
    
    
    
    AverageAmount
    
    Rate
    
    Amount
    
    RateInterest income:Mortgage securities and other investments
    
    $
    19,279
    
    
    
    3.10
    %
    
    $
    21,648
    
    
    
    4.06
    %CMO collateral and investments
    
    
    1,866
    
    
    
    6.46
    
    
    
    10,122
    
    
    
    6.19Total interest income
    
    
    21,145
    
    
    
    
    
    
    
    31,770Interest expense:Repurchase arrangements and similar
borrowings
    
    
    6,967
    
    
    
    1.20
    
    
    
    6,454
    
    
    
    1.30CMO borrowings
    
    
    1,659
    
    
    
    5.74
    
    
    
    10,010
    
    
    
    6.08Total interest expense
    
    
    8,626
    
    
    
    
    
    
    
    16,464$
    12,519
    
    
    
    
    
    
    $
    15,306
 Six Months Ended June 302004
    
    2003Amount
    
    Average
    
    Amount
    
    AverageInterest income:Mortgage securities and similar investments
    
    $
    38,716
    
    
    
    3.25
    %
    
    $
    46,785
    
    
    
    4.21
    %CMO collateral and investments
    
    
    4,372
    
    
    
    6.55
    
    
    
    25,090
    
    
    
    6.33Total interest income
    
    
    43,088
    
    
    
    
    
    
    
    71,875Interest expense:Repurchase arrangements and similar
borrowings
    
    
    12,797
    
    
    
    1.16
    
    
    
    13,673
    
    
    
    1.32CMOs borrowings
    
    
    3,952
    
    
    
    5.93
    
    
    
    25,349
    
    
    
    6.39Total interest expense
    
    
    16,749
    
    
    
    
    
    
    
    39,022$
    26,339
    
    
    
    
    
    
    $
    32,853
 -14-




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##### Table of Contents



Changes in interest income and interest expense due to changes in interest
rates versus changes in volume were as follows (in thousands): Quarter Ended June 30, 2004Rate*
    
    Volume*
    
    TotalInterest income:Mortgage securities and similar investments
    
    $
    (5,600
    )
    
    $
    3,231
    
    
    $
    (2,369
    )CMO collateral and investments
    
    
    419
    
    
    
    (8,675
    )
    
    
    (8,256
    )Total interest income
    
    
    (5,181
    )
    
    
    (5,444
    )
    
    
    (10,625
    )Interest expense:Repurchase arrangements and similar
borrowings
    
    
    (528
    )
    
    
    1,041
    
    
    
    513CMOs
    
    
    (520
    )
    
    
    (7,831
    )
    
    
    (8,351
    )Total interest expense
    
    
    (1,048
    )
    
    
    (6,790
    )
    
    
    (7,838
    )$
    (4,133
    )
    
    $
    1,346
    
    
    $
    (2,787
    )
 Six Months Ended June 30, 2004Rate*
    
    Volume*
    
    TotalInterest income:Mortgage securities and similar investments
    
    $
    (11,213
    )
    
    $
    3,144
    
    
    $
    (8,069
    )CMO collateral and investments
    
    
    858
    
    
    
    (21,576
    )
    
    
    (20,718
    )Total interest income
    
    
    (10,355
    )
    
    
    (18,432
    )
    
    
    (28,787
    )Interest expense:Repurchase arrangements and similar
borrowings
    
    
    (1,765
    )
    
    
    889
    
    
    
    (876
    )CMOs
    
    
    (1,721
    )
    
    
    (19,676
    )
    
    
    (21,397
    )Total interest expense
    
    
    (3,486
    )
    
    
    (18,787
    )
    
    
    (22,273
    )$
    (6,869
    )
    
    $
    355
    
    
    $
    (6,514
    )
   *
    
    The change in interest due to both volume and rate has
been allocated to volume and rate changes in proportion to the
relationship of the absolute dollar amounts of the change in
each. NOTE 14  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. In July 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 an incentive fee program based on
the Companys expected performance against predetermined benchmarks established
by members of the Board of Directors independent of Fortress. Included in
Other operating expenseis $93,750 and $187,500 of base fees paid to Fortress
for services rendered during the quarter and six months ended June 30, 2003,
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. -15-




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##### Table of Contents



ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS FINANCIAL CONDITION Overview Capstead Mortgage Corporation (Capstead or the Company) operates as a real
estate investment trust (REIT) earning income from investing in real
estate-related assets on a leveraged basis and from other investment
strategies. These investments primarily consist of, but are not limited to,
residential 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 that 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 the Companys investment portfolios depend on the
investment strategies being implemented by management and market conditions
being experienced by the Company, including the relationship between short- and
long-term interest rates (the yield curve), levels of mortgage prepayments
and the availability of attractively priced investments. During the latter
half of 2003, Capstead acquired sufficient ARM securities at relatively
attractive prices to more than offset portfolio runoff for the first time in
several years. This trend continued during the first six months of 2004 such
that the Company was successful in growing the mortgage securities and similar
investments portfolio by over $400 million since year end to $2.6 billion at
June 30, 2004. The Company intends to continue pursuing the acquisition of
attractively priced ARM securities, while also investigating other real
estate-related opportunities. On June 30, 2004, in response to current growth prospects for the United States
economy, the Federal Reserve Open Market Committee (the Federal Reserve)
raised the Federal Funds Rate 25 basis points in the first of a series of
expected moves to increase short-term interest rates. Higher short-term
interest rates will increase the Companys borrowing costs, thereby reducing
financing spreads (the difference between the yields earned on these
investments and the rates charged on related borrowings). Although the effects
of rising borrowing costs on financing spreads can eventually be mitigated by
ARM security yield increases, 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 reset only
once or twice 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 will decline in the immediately ensuing
quarters before the benefits of ARM security yield increases are fully
realized. Results of Capital Raising Activity Between February 2 and June 30, 2004, the Company sold 2,019,400 common shares
into the open market on a limited basis and such sales resumed during the third
quarter. As of quarter-end, Capstead raised nearly $30 million of new common
equity with these sales at an average price of $14.80 per share, after
expenses. The proceeds from these issuances have been invested in
attractively-priced ARM securities. -16-




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##### Table of Contents



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,
Investment Company Act of 1940 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. Mortgage Securities and Similar Investments As of June 30, 2004, the mortgage securities and similar investments portfolio
consisted primarily of ARM Agency Securities. Agency Securities are AAA-rated
and are 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 June 30,
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 Companys mortgage securities and similar investments portfolio rose during
the first six months of 2004 to $2.6 billion from $2.2 billion at December 31,
2003, representing the fourth straight quarter of portfolio growth after
several years of declines. Acquisitions during the quarter and six months ended
June 30, 2004 totaled $410 million and $770 million, respectively, consisting
almost exclusively of ARM Agency Securities. Runoff caused by mortgage
prepayments remains a challenge to earnings generated by the Companys mortgage
securities. Runoff during the second quarter totaled $202 million, higher than
the $148 million experienced during the first quarter of 2004 but less than the
$225 million incurred during the fourth quarter of 2003. Runoff was higher
during the second quarter in part due to higher portfolio balances, but also
reflecting higher levels of mortgage prepayments in recent months, due largely
to a brief drop in mortgage interest rates late in the first quarter. These
lower rates provided homeowners, who for the first time in several years are
facing higher resets on their ARM loans, another opportunity to refinance into
fixed-rate mortgages at interest rates near the historically low levels
experienced in 2003. Although the Company has had continued success subsequent to quarter-end
acquiring additional ARM securities such that it expects further portfolio
growth during the third quarter of 2004, 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 rates of return on invested capital at
least equal to the returns earned on previous investments, earnings and common
dividends will likely 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. -17-




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##### Table of Contents



The following yield and cost analysis illustrates results achieved during the
second quarter of 2004 for components of the mortgage securities and similar
investments portfolio and anticipated third quarter 2004 asset yields and
borrowing rates based on interest rates in effect on July 22, 2004 (the date
second quarter 2004 results were released) (dollars in thousands): 2nd Quarter Average (a)
    
    As of June 30, 2004Projected
    
    LifetimeActual
    
    Actual
    
    Premiums
    
    
    
    
    
    3rd Quarter
    
    RunoffBasis
    
    Yield/Cost
    
    Runoff
    
    (Discounts)
    
    Basis(a)
    
    Yield/Cost(b)
    
    AssumptionsAgency Securities:Fannie Mae/Freddie
Mac:Fixed-rate
    
    $
    51,106
    
    
    
    5.98
    %
    
    
    50
    %
    
    $
    196
    
    
    $
    46,206
    
    
    
    6.16
    %
    
    
    39
    %ARMs:LIBOR/CMT
    
    
    1,254,152
    
    
    
    2.79
    
    
    
    29
    
    
    
    22,410
    
    
    
    1,296,481
    
    
    
    2.76
    
    
    
    28COFI
    
    
    79,628
    
    
    
    4.49
    
    
    
    28
    
    
    
    (2,257
    )
    
    
    75,788
    
    
    
    4.36
    
    
    
    27Ginnie Mae ARMs
    
    
    905,310
    
    
    
    3.17
    
    
    
    28
    
    
    
    10,033
    
    
    
    995,231
    
    
    
    3.11
    
    
    
    292,290,196
    
    
    
    3.07
    
    
    
    29
    
    
    
    30,382
    
    
    
    2,413,706
    
    
    
    3.02
    
    
    
    28Non-agency Securities:Fixed-rate
    
    
    45,333
    
    
    
    6.19
    
    
    
    42
    
    
    
    54
    
    
    
    42,352
    
    
    
    6.38
    
    
    
    38ARMs
    
    
    69,981
    
    
    
    3.20
    
    
    
    27
    
    
    
    906
    
    
    
    66,899
    
    
    
    3.60
    
    
    
    37115,314
    
    
    
    4.37
    
    
    
    34
    
    
    
    960
    
    
    
    109,251
    
    
    
    4.67
    
    
    
    37CMBS
    
    
    73,135
    
    
    
    2.19
    
    
    
    1
    
    
    
    3
    
    
    
    73,072
    
    
    
    2.74
    
    
    
    12,478,645
    
    
    
    3.10
    
    
    
    29
    
    
    $
    31,345
    
    
    
    2,596,029
    
    
    
    3.08
    
    
    
    28Related borrowings:< 90 day maturities
    
    
    2,089,917
    
    
    
    1.10
    
    
    
    
    
    
    
    
    
    
    
    2,077,608
    
    
    
    1.49> 90 day maturities
    
    
    204,059
    
    
    
    2.20
    
    
    
    
    
    
    
    
    
    
    
    308,463
    
    
    
    2.202,293,976
    
    
    
    1.20
    
    
    
    
    
    
    
    
    
    
    
    2,386,071
    
    
    
    1.58Capital employed/
financing spread
    
    $
    184,669
    
    
    
    1.90
    
    
    
    
    
    
    
    
    
    
    $
    209,958
    
    
    
    1.50Return on assets (c)
    
    
    
    
    
    
    1.98
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1.60
   (a)
    
    Basis represents the Companys investment before unrealized gains and
losses. Actual asset yields, runoff rates, borrowing rates and resulting
financing spread are presented on an annualized basis.(b)
    
    Projected annualized yields for the third quarter of 2004 reflect ARM
coupon resets and lifetime runoff assumptions as adjusted for expected
prepayments for this quarter only, as of July 22, 2004. Actual yields
realized in future periods will largely depend upon (i) changes in
portfolio composition, (ii) ARM coupon resets, (iii) actual prepayments
and (iv) any changes in lifetime runoff assumptions. Interest rates on
borrowings with less than 90 day maturities reflect expectations for 25
basis point increases in the Federal Funds Rate on August 10 and
September 21, 2004.(c)
    
    Return on assets is calculated on an annualized basis assuming the use
of the Companys liquidity to reduce borrowing costs (see Utilization of
Capital and Potential Liquidity). Financing spreads declined 41 basis points during the second quarter of 2004 to
1.90%, attributable to both lower portfolio yields and higher borrowing costs.
The overall yield earned on the portfolio averaged 3.10% during the second
quarter, compared to an average yield of 3.42% earned during the prior quarter.
Yields on ARM securities are affected by levels of mortgage prepayments and,
more importantly, fluctuate as coupon interest rates on the underlying mortgage
loans reset to reflect current interest rates. Current quarter yields reflect
the effects of relatively high mortgage prepayments and the trend of downward
resets in coupon interest rates experienced the last several years. However,
because of the higher current interest rate environment, coupon interest rates
are expected to begin trending higher resulting in improving yields from this
portfolio in the coming quarters. For example, if interest rates remain at
rates in effect July 22, 2004, the average yield on the portfolio could
increase approximately 46 basis points by the second quarter of 2005. Actual
yields will depend on portfolio composition as well as fluctuations in, and
market expectations for fluctuations in, interest rates and levels of mortgage
prepayments. -18-




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##### Table of Contents



Average rates on borrowings secured by mortgage securities and similar
investments increased nine basis points to 1.20% during the second quarter of
2004 compared to the previous quarter and are expected to increase further in
future quarters. On June 30, 2004 the Federal Reserve raised the Federal Funds
Rate 25 basis points in the first of a series of expected moves to increase
short-term interest rates in response to current growth expectations for the
United States economy. Although the Company primarily uses 30-day repurchase
arrangements to finance its mortgage investments, early in the second quarter
the Company extended maturities for up to two years on $308 million of its
borrowings related to the Companys modest position in fixed-rate securities
and certain longer-to-reset ARM securities. By doing so the Company
effectively locked in attractive financing spreads over the expected fixed-rate
terms of these investments. 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 and Investments Since exiting the residential mortgage loan conduit business in 1995, Capstead
has maintained finance subsidiaries with capacity to issue CMOs and other
securitizations backed by residential mortgage loans. The last CMO issued by
the Company was in 2000 and the Company does not currently anticipate issuing
additional CMOs. In recent years, the Company has 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 of June 30,
2004, the Company holds Clean-up Call rights on only one of its six remaining
CMOs. Consequently, additional significant gains from CMO redemptions are not
expected to occur. CMO collateral and investments, net of related bonds, was
$636,000 at June 30, 2004, compared to $764,000 at December 31, 2003. Without
the issuance of CMOs in which the Company retains residual interests, or the
acquisition of other CMO investments, this portfolio is not expected to
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 most of the 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, which, together with its affiliates is referred to as Fortress. Until
July 2003 Fortress was affiliated with Capstead (see NOTE 14 to the
accompanying financial statements). The following table summarizes information
about the Properties: YearProperty
    
    Location
    
    Units (a)
    
    Occupancy (b)
    
    OpenedChambrel at Roswell
    
    Roswell, GA
    
    280 (256 IL; 24 AL)
    
    
    96.8
    %
    
    
    1987Chambrel at Pinecastle
    
    Ocala, FL
    
    161 (120 IL; 41 AL)
    
    
    96.9
    
    
    
    1987Chambrel at Island Lake
    
    Longwood, FL
    
    269 (229 IL; 40 AL)
    
    
    97.4
    
    
    
    1985Chambrel at Montrose
    
    Akron, OH
    
    168 (136 IL; 32 AL)
    
    
    99.4
    
    
    
    1987Chambrel at Williamsburg
    
    Williamsburg, VA
    
    255 (200 IL; 55 AL)
    
    
    98.8
    
    
    
    1987Chambrel at Club Hill
    
    Garland, TX
    
    260 (192 IL; 68 AL)
    
    
    90.0
    
    
    
    1987Total
    
    
    
    1,393 (1,133 IL; 260 AL)
    
    
    96.3
   (a)
    
    IL refers to independent living units. AL refers to assisted living units.(b)
    
    As of June 30, 2004. -19-




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##### Table of Contents



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 owning investments that can produce
attractive risk-adjusted returns over the long term with relatively low
sensitivity to changes in interest rates, any future changes in monthly debt
service requirements are the responsibility of Brookdale under the terms of the
Lease. Book Value per Common Share As of June 30, 2004, the Companys book value per common share was $6.88, an
increase of $0.21 from December 31, 2003. Increases in book value from raising
common equity capital at prices in excess of book value more than offset the
effects of (i) declines in the aggregate unrealized gain on the Companys
mortgage securities and similar investments portfolio because of portfolio
runoff and higher prevailing interest rates; and (ii) dividend payments in
excess of GAAP net income. Common stock issuances contributed $1.04 per share
to book value while declines 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 incomelowered book value by $0.72 per share.
Dividend payments in excess of GAAP net income, which results primarily because
the Company currently distributes all cash flow from its net-leased real
estate, ignoring non-cash depreciation charges, lowered book value by $0.11 per
share. The unrealized gain on the Companys mortgage securities and similar
investments portfolio can be expected to fluctuate with changes in portfolio
size and composition as well as changes in interest rates and market liquidity,
and 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. 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. Similarly, 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, neither 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). -20-




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##### Table of Contents



The following table illustrates Capsteads utilization of capital and potential
liquidity as of June 30, 2004 in comparison with December 31, 2003 (in
thousands): Capital
    
    PotentialAssets (a)
    
    Borrowings
    
    Employed
    
    Liquidity (a)Mortgage securities and similar
investments:Agency Securities
    
    $
    2,429,608
    
    
    $
    2,231,494
    
    
    $
    198,114
    
    
    $
    130,255Non-agency Securities
    
    
    109,984
    
    
    
    85,937
    
    
    
    24,047
    
    
    
    17,207CMBS
    
    
    73,070
    
    
    
    68,640
    
    
    
    4,430
    
    
    
    4192,612,662
    
    
    
    2,386,071
    
    
    
    226,591
    
    
    
    147,881CMO collateral and investments
    
    
    105,311
    
    
    
    104,675
    
    
    
    636
    
    
    
    Real estate held for lease
    
    
    131,559
    
    
    
    120,101
    
    
    
    11,458
    
    
    
    $
    2,849,532
    
    
    $
    2,610,847
    
    
    
    238,685
    
    
    
    147,881Other assets, net of other liabilities
    
    
    
    
    
    
    
    
    
    
    63,256
    
    
    
    24,329
    (b)Second quarter common dividend
    
    
    
    
    
    
    
    
    
    
    (7,994
    )
    
    
    (7,994)
    (c)Liquidity reserves for funding principal
payments and margin calls
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (131,000
    )$
    293,947
    
    
    $
    33,216Balances as of December 31, 2003
    
    $
    2,496,102
    
    
    $
    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 borrowings available under
existing uncommitted repurchase arrangements considering the fair value
of related collateral as of June 30, 2004, adjusted separately for
liquidity reserves.(b)
    
    Represents unrestricted cash and cash equivalents and proceeds of
stock issuances that settled in early July.(c)
    
    The second quarter 2004 common dividend was declared June 10, 2004 and
paid July 21, 2004 to stockholders of record as of June 30, 2004. Since year-end, Capstead has invested proceeds from portfolio runoff and
capital raising activities, and a portion of its remaining potential
liquidity, into additional ARM securities. With the resulting growth of the
mortgage securities and similar investments portfolio, required liquidity
reserves have increased correspondingly from $115 million at December 31,
2003 to $131 million at June 30, 2004. 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. -21-




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##### Table of Contents



RESULTS OF OPERATIONS Comparative net operating results (interest income or lease revenue, net of
related interest expense and, in the case of CMO administration, related direct
and indirect operating expense) by source were as follows (in thousands, except
per share amounts): Quarter Ended
    
    Six Months EndedJune 30
    
    June 302004
    
    2003
    
    2004
    
    2003Mortgage securities and similar investments:Agency Securities
    
    $
    11,156
    
    
    $
    13,195
    
    
    $
    22,829
    
    
    $
    28,981Non-agency Securities
    
    
    927
    
    
    
    1,029
    
    
    
    2,628
    
    
    
    2,074CMBS and other commercial loans
    
    
    180
    
    
    
    903
    
    
    
    362
    
    
    
    1,917CMO collateral and investments
    
    
    189
    
    
    
    80
    
    
    
    406
    
    
    
    (327
    )Net margin on financial assets
    
    
    12,452
    
    
    
    15,207
    
    
    
    26,225
    
    
    
    32,645Real estate held for lease:Lease revenue net of related interest
expense
    
    
    1,373
    
    
    
    1,442
    
    
    
    2,813
    
    
    
    2,871Real estate depreciation
    
    
    (927
    )
    
    
    (927
    )
    
    
    (1,854
    )
    
    
    (1,854
    )Net margin on real estate held for lease
    
    
    446
    
    
    
    515
    
    
    
    959
    
    
    
    1,017Other revenue (expense):Gain on asset sales and CMO redemptions
    
    
    
    
    
    
    1,392
    
    
    
    
    
    
    
    3,140CMO administration and other
    
    
    249
    
    
    
    181
    
    
    
    316
    
    
    
    401Incentive fee payable to former affiliate
    
    
    
    
    
    
    (197
    )
    
    
    
    
    
    
    (500
    )Other operating expense
    
    
    (1,332
    )
    
    
    (1,857
    )
    
    
    (3,331
    )
    
    
    (3,919
    )Total other revenue (expense)
    
    
    (1,083
    )
    
    
    (481
    )
    
    
    (3,015
    )
    
    
    (878
    )Net income
    
    
    11,815
    
    
    
    15,241
    
    
    
    24,169
    
    
    
    32,784Less cash dividends on preferred shares
    
    
    (5,064
    )
    
    
    (5,068
    )
    
    
    (10,131
    )
    
    
    (10,138
    )Net income available to common stockholders
    
    $
    6,751
    
    
    $
    10,173
    
    
    $
    14,038
    
    
    $
    22,646Operating income *
    
    $
    7,759
    
    
    $
    9,793
    
    
    $
    16,057
    
    
    $
    21,533Weighted average shares outstanding:Basic
    
    
    15,237
    
    
    
    13,978
    
    
    
    14,752
    
    
    
    13,957Diluted
    
    
    15,578
    
    
    
    23,270
    
    
    
    15,100
    
    
    
    23,240Operating *
    
    
    15,578
    
    
    
    14,327
    
    
    
    15,100
    
    
    
    14,313Net income per common share:Basic
    
    $
    0.44
    
    
    $
    0.73
    
    
    $
    0.95
    
    
    $
    1.62Diluted
    
    
    0.44
    
    
    
    0.65
    
    
    
    0.94
    
    
    
    1.41Operating *
    
    
    0.50
    
    
    
    0.68
    
    
    
    1.06
    
    
    
    1.50
  *
    
    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 $2.18 (the Series B preferred share annualized
dividend of $1.26 divided by the current conversion rate of 0.5776).
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. -22-




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The earning capacity of Capsteads financial asset portfolios is influenced by
the overall size and composition of the portfolios, the relationship between
short- and long-term interest rates (the yield curve) and the extent the
Company continues to invest its liquidity in these portfolios. Net margins on
financial assets and related financing spreads benefited significantly the past
several years from actions taken by the Federal Reserve, particularly during
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 declining yields on the Companys adjustable-rate assets and relatively
high mortgage prepayment rates. On June 30, 2004 the Federal Reserve began increasing short-term interest rates
in response to current growth expectations for the United States economy.
Because the majority of Capsteads financial asset portfolios currently consist
of ARM securities backed by mortgage loans with coupon interest rates that
reset at least annually, management believes Capstead is positioned to
withstand the anticipated higher interest rate environment, albeit at reduced
financing spreads. Consequently, as increasing short-term interest rates
reduce current financing spreads, earnings and dividends will decline in the
immediately ensuing quarters before the benefits of ARM security yield
increases are fully realized. See Financial Condition  Overview and
Mortgage Securities and Similar Investments for further discussion of the
current operating environment and the Companys goals regarding redeploying
capital made available by portfolio runoff. Agency Securities remained the primary contributor to operating results during
the quarter and six months ended June 30, 2004; however, the impact of lower
financing spreads was evident in the current quarter results, which were less
than in the same periods in 2003 despite lower borrowing rates. Yields for
this portfolio averaged 3.07% and 3.19% during the quarter and six months ended
June 30, 2004 while borrowing rates averaged 1.19% and 1.13%, during the
quarter and six months ended June 30, 2004, producing financing spreads of
1.88% and 2.06%. This compares with yields of 4.01% and 4.16% and borrowing
rates of 1.25% and 1.27% for spreads of 2.76% and 2.89% during the same periods
in 2003. The average outstanding Agency Securities portfolio was $2.3 billion
and $2.1 billion during the quarter and six months ended June 30, 2004,
compared to $1.9 billion and $2.0 billion during the same periods in 2003. The Non-Agency Securities portfolio contribution to operating results during
the quarter ended June 30, 2004 slightly lagged the prior year results
primarily because of a lower outstanding portfolio. The portfolio declined
with runoff and the securitization of $53 million of high coupon fixed-rate
Non-Agency Securities with Fannie Mae in March 2004. On a year-to-date basis,
this portfolio exceeded prior year primarily because of the benefits of
additional securities made available from the redemption of CMOs during the
latter part of 2003. The average outstanding portfolio was $115 million and
$152 million during the quarter and six months ended June 30, 2004 compared to
$131 million and $115 million during the same periods in 2003. The portfolio
yielded 4.37% and 4.69% during the quarter and six months ended June 30, 2004,
while borrowing rates averaged 1.44% and 1.49%, producing financing spreads of
2.93% and 3.20%. This compares with yields of 3.81% and 4.24% and borrowing
rates of 1.48% and 1.45% for spreads of 2.33% and 2.79% during the same periods
in 2003. CMBS and other commercial loans contributed significantly less to operating
results during the quarter and six months ended June 30, 2004 than in the same
periods in 2003 due largely to payoffs during 2003 of several higher yielding
investments. The average outstanding portfolio was $73 million during the
quarter and six months ended June 30, 2004 compared to $110 million and $126
million during the same periods in 2003. The portfolio yielded 2.19% during
the quarter and six months ended June 30, 2004 while borrowing rates averaged
1.30% and 1.29% producing financing spreads of 0.89% and 0.90%. This compares
with yields of 5.12% and 4.87% and borrowing rates of 2.13% and 2.11% for
spreads of 2.99% and 2.76% during the same periods in 2003. -23-




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The CMO collateral and investments portfolio has declined significantly the
last several years primarily because of high prepayments on the underlying
pledged CMO collateral and the exercise of Clean-up Calls in which the Company
redeemed the related bonds and either sold the released CMO collateral for
gains or transferred it into the Non-agency Securities portfolio to be held for
investment. Having redeemed over the past several years nearly all outstanding CMOs to
which the Company holds the related Clean-up Call rights, Capstead has not
realized any gain on asset sales and CMO redemptions during 2004. 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 during the current quarter included
a $100,000 recovery of a previously written-off mortgage loan. Other operating expenses (including incentive fees payable to former affiliate)
were lower during the quarter and six months ended June 30, 2004 than during
the same periods in 2003 primarily because of lower current year accruals for
incentive fees. These lower incentive fee accruals reflect current
expectations for lower 2004 earnings due primarily to lower financing spreads
and the effects on book value of declines in unrealized gains on mortgage
securities. 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 June 30, 2004, as adjusted for 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 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 $308 million of these borrowings during the current quarter (see discussion
above under Mortgage Securities and Similar Investments). Borrowings secured
by Agency Securities and Non-agency Securities totaled $2.3 billion at June 30,
2004. Capstead has uncommitted repurchase facilities with investment banking
firms to finance these investments, subject to certain conditions. Interest
rates on these borrowings are generally based on 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. -24-




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Borrowings under repurchase arrangements with investment banking firms secured
by CMBS more closely match the interest rate adjustment features of these
investments such that the Company anticipates it can earn more consistent
financing spreads and, as a result, experience less interest rate volatility
than experienced with investments in Agency Securities. These borrowings,
which generally have longer initial maturities than borrowings secured by
Agency Securities and may feature renewal options, totaled $69 million at June
30, 2004. Should Capstead make significant additional investments in
credit-sensitive assets, it may 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 $105 million at June 30, 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. Beginning in February 2004 the Company began selling common shares into the
open market on a limited basis and such sales have resumed during the third
quarter. The proceeds from future issuances, together with Capsteads
existing liquidity, are available to fund further acquisitions of ARM
securities, if available at attractive prices, and increase the Companys
flexibility in pursuing real estate-related opportunities. 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 and liability premiums and discounts. These assumptions
are developed through a combination of historical analysis and future expected
pricing behavior. Income simulation modeling is the primary tool used 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, therefore, 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. -25-




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Capstead had the following estimated earnings sensitivity profile as of June
30, 2004 and December 31, 2003, respectively (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:June 30, 2004
    
    
    1.37
    %
    
    
    4.59
    %
    
    $
    (1,606
    )
    
    $
    (10,002
    )
    
    $
    (9,713
    )
    
    $
    (23,577
    )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
guarantee that suitable investments will be available for purchase at
attractive prices or if investments made will behave in the same
fashion as assets currently held. General Discussion of Effects of Interest Rate Changes Changes in interest rates may affect Capsteads earnings in various ways.
Earnings currently depend, in 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 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 reset once or twice a year based on underlying indices, subject to
periodic and lifetime limits, referred to as caps. The Companys ARM
securities featured the following average coupon rate, and average periodic and
lifetime caps as of June 30, 2004 (dollars in thousands): Average
    
    Average
    
    AverageARM Type
    
    Basis *
    
    Coupon Rate
    
    Periodic Cap
    
    Lifetime CapAgency Securities:Fannie Mae/Freddie Mac
    
    $
    1,372,269
    
    
    
    3.51
    %
    
    
    1.779
    %
    
    
    11.021
    %Ginnie Mae
    
    
    995,231
    
    
    
    4.05
    
    
    
    1.000
    
    
    
    10.148Non-agency Securities
    
    
    66,899
    
    
    
    3.93
    
    
    
    1.728
    
    
    
    11.232$
    2,434,399
    
    
    
    3.74
    
    
    
    1.459
    
    
    
    10.669
   *
    
    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 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. The Company
may extend maturity dates on a portion of its short-term borrowings (as it did
during the current quarter) or invest in Derivatives from time to time as a
hedge against rising interest rates. As of the filing date of this report, the
Company does not own any Derivatives for this purpose. -26-




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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 rates of return at least equal to the rates 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 to the amount of the borrowing. If the Company is unable or
unwilling to pledge additional collateral, lenders can liquidate the collateral
under adverse market conditions, likely resulting in losses. RISKS ASSOCIATED WITH CREDIT-SENSITIVE INVESTMENTS Commercial mortgage assets may be viewed as exposing an investor to greater
risk of loss than residential mortgage assets since such assets are typically
secured by larger loans to fewer obligors than residential mortgage assets.
Commercial property values and related net operating income are often subject
to volatility, and net operating income may be sufficient or insufficient to
cover debt service on the related mortgage loan at any given time. The
repayment of loans secured by income-producing properties is typically
dependent upon the successful operation of the related real estate project and
the ability of the applicable property to produce net operating income rather
than upon the liquidation value of the underlying real estate. Even when the
current net operating income is sufficient to cover debt service, there can be
no assurance that this will continue to be the case in the future. Additionally, commercial properties may not be readily convertible to
alternative uses if such properties were to become unprofitable due to
competition, age of improvements, decreased demand, regulatory changes or other
factors. The conversion of commercial properties to alternate uses often
requires substantial capital expenditures, which may or may not be available. The availability of credit for commercial mortgage loans may be dependent upon
economic conditions in the markets where such properties are located, as well
as the willingness and ability of lenders to make such loans. The availability
of funds in the credit markets fluctuates and there can be no assurance that
the availability of such funds will increase above, or will not contract below
current levels. In addition, the availability of similar commercial
properties, and the competition for available credit, may affect the ability of
potential purchasers to obtain financing for the acquisition of properties.
This could effect the repayment of commercial mortgages. Credit-sensitive residential mortgage assets differ from commercial mortgage
assets in several important ways yet can still carry substantial credit risk.
Residential mortgage securities typically are secured by smaller loans to more
obligors than CMBS, thus spreading the risk of mortgagor default. However,
most of the mortgages supporting 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 -27-




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commercial mortgages, in instances of default the Company may incur losses if
proceeds from sales of the underlying residential collateral are less than the
unpaid principal balances of the residential mortgage loans and related
foreclosure costs. However, with residential mortgages this risk may be
mitigated by various forms of credit enhancements including, but not limited
to, primary mortgage insurance. Through the process of securitizing both commercial and residential mortgages,
credit risk can be heightened or minimized. Senior classes in multi-class
securitizations generally have first priority over cash flows from a pool of
mortgages and, as a result, carry the least risk, highest investment ratings
and the lowest yields. Typically, a securitization will also have mezzanine
classes and subordinated classes. Mezzanine classes will generally have lower
credit ratings, higher yields and may have average lives that are longer than
the senior classes. Subordinate classes are junior in the right to receive
cash flow from the underlying mortgages, thus providing credit enhancement to
the senior and mezzanine classes. As a result, subordinated securities will
have even lower credit ratings and higher yields because of the elevated risk
of credit loss inherent in these securities. The availability of capital from external sources to finance investments in
credit-sensitive commercial and residential mortgage assets may be diminished
during periods of mortgage finance market illiquidity. 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 required to
modify the property for a different use, which may involve significant capital expenditures and delays in re-leasing the
property. -28-




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
    
    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, and 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. Although typically these expenditures would be the
responsibility of the lessee under the terms of net-leases, 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 so 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.  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. -29-




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
    
    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 in the
future 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 the properties 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. INVESTMENT COMPANY ACT OF 1940 The Investment Company Act of 1940, as amended (the Investment Company Act),
exempts entities that are primarily engaged in the business of purchasing or
otherwise acquiring mortgages and other liens on, and interests in, real
estate. Capstead intends to conduct its business so as not to become regulated
as an investment company under the Investment Company Act. If the Company
fails to qualify for this exemption, its 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 qualify for this exemption a REIT must maintain
at least 55% of its assets directly in qualifying real estate interests.
Mortgage-backed securities that do not represent all of the certificates issued
with respect to an underlying pool of mortgages (Non-whole Pool Securities)
may be treated as separate from the underlying mortgage loans and, thus, may
not qualify for purposes of the 55% requirement. Therefore, the provisions of
the Investment Company Act limit ownership of these mortgage-backed securities. In satisfying the 55% requirement under the Investment Company Act, a REIT may
treat mortgage-backed securities issued with respect to an underlying pool to
which it holds all issued certificates (Whole Pool Securities) 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 Non-whole Pool Securities or other non-qualified assets
under potentially adverse market conditions. Further, in order to ensure
continued qualification for the exemption under the Investment Company Act, a
REIT might be precluded from acquiring Non-whole Pool Securities even if their
yield is higher than the yield of Whole Pool Securities. These factors may
lower earnings. 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 (see Effects of Interest Rate Changes). -30-




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
    
    Fair Value and Impairment Accounting for Financial Assets Most of
Capsteads mortgage securities and similar investments portfolio and a
small portion of its CMO collateral and investments portfolio 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. 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. 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, Risks of Interest Rate Changes and Risks
Associated with Credit-Sensitive Investments).
    
    Depreciation and Impairment Accounting for Real Estate held for Lease
 Real estate is carried on the Companys balance sheet 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 (see
Risks Associated with Owning Real Estate). 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 qualifying 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. -31-




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##### Table of Contents



COMPARISON OF OPERATING INCOME AND DILUTED INCOME PER SHARE The following table compares the calculation of operating income and operating
income per common share to net income and diluted net income per share (in
thousands, except per share amounts): Quarter EndedJune 30, 2004
    
    March 31, 2004
    
    June 30, 2003Operating
    
    Diluted
    
    Operating
    
    Diluted
    
    Operating
    
    DilutedNet income
    
    $
    11,815
    
    
    $
    11,815
    
    
    $
    12,354
    
    
    $
    12,354
    
    
    $
    15,241
    
    
    $
    15,241Adjustments for:Depreciation on real estate
    
    
    927
    
    
    
    
    
    
    
    927
    
    
    
    
    
    
    
    927
    
    
    
    Gain on asset sales and
CMO redemptions
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,393
    )
    
    
    Series B preferred dividends
    
    
    (4,983
    )
    
    
    (4,983
    )
    
    
    (4,983
    )
    
    
    (4,983
    )
    
    
    (4,982
    )
    
    
    $
    7,759
    
    
    $
    6,832
    
    
    $
    8,298
    
    
    $
    7,371
    
    
    $
    9,793
    
    
    $
    15,241Weighted average common
shares outstanding
    
    
    15,237
    
    
    
    15,237
    
    
    
    14,267
    
    
    
    14,267
    
    
    
    13,978
    
    
    
    13,978Net effect of dilutive
securities:Preferred B shares
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    8,943Stock options and other
preferred shares
    
    
    341
    
    
    
    341
    
    
    
    353
    
    
    
    353
    
    
    
    349
    
    
    
    34915,578
    
    
    
    15,578
    
    
    
    14,620
    
    
    
    14,620
    
    
    
    14,327
    
    
    
    23,270$
    0.50
    
    
    $
    0.44
    
    
    $
    0.57
    
    
    $
    0.50
    
    
    $
    0.68
    
    
    $
    0.65
 Six Months EndedJune 30, 2004
    
    June 30, 2003Operating
    
    Diluted
    
    Operating
    
    DilutedNet income
    
    $
    24,169
    
    
    $
    24,169
    
    
    $
    32,784
    
    
    $
    32,784Adjustments for:Depreciation on real estate
    
    
    1,854
    
    
    
    
    
    
    
    1,854
    
    
    
    Gain on asset sales and
CMO redemptions
    
    
    
    
    
    
    
    
    
    
    (3,140
    )
    
    
    Series B preferred dividends
    
    
    (9,966
    )
    
    
    (9,966
    )
    
    
    (9,965
    )
    
    
    $
    16,057
    
    
    $
    14,203
    
    
    $
    21,533
    
    
    $
    32,784Weighted average common
shares outstanding
    
    
    14,752
    
    
    
    14,752
    
    
    
    13,957
    
    
    
    13,957Net effect of dilutive securities:Preferred B shares
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    8,927Stock options and other
preferred shares
    
    
    348
    
    
    
    348
    
    
    
    356
    
    
    
    35615,100
    
    
    
    15,100
    
    
    
    14,313
    
    
    
    23,240$
    1.06
    
    
    $
    0.94
    
    
    $
    1.50
    
    
    $
    1.41
 -32-




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##### Table of Contents



ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE OF MARKET RISKS The information required by this Item is incorporated by reference to the
information included in Item 2. Managements Discussion and Analysis of
Financial Condition and Results of Operations. 
 ITEM 4. CONTROLS AND PROCEDURES As of June 30, 2004, an evaluation was performed under the supervision and with
the participation of the Companys management, including the CEO and Chief
Financial Officer (CFO), of the effectiveness of the design and operation of
the Companys disclosure controls and procedures. Based on that evaluation,
the Companys management, including the CEO and CFO, concluded that the
Companys disclosure controls and procedures were effective as of June 30,
2004. There have been no significant changes in the Companys internal
controls or in other factors that could significantly affect internal controls
subsequent to June 30, 2004. 
 PART II.  OTHER INFORMATION 
 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K  (a)
    
    Exhibits: The following Exhibits are presented herewith:Exhibit 12  Computation of Ratio of Earnings to Combined Fixed Charges and
Preferred Stock Dividends.Exhibit 31.1  Certification pursuant to Section 302(a) of the
Sarbanes-Oxley Act of 2002Exhibit 31.2  Certification pursuant to Section 302(a) of the
Sarbanes-Oxley Act of 2002Exhibit 32  Certification pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002(b)
    
    Reports on Form 8-K:Current Report on Form 8-K dated April 22, 2004 announcing first quarter
2004 financial results. -33-




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##### Table of Contents



SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the Company has duly caused this report to be signed on its behalf
by the undersigned, thereunto duly authorized. CAPSTEAD MORTGAGE CORPORATION
RegistrantDate: August 6, 2004
    By:
    /s/ ANDREW F. JACOBSAndrew F. JacobsPresident and Chief Executive OfficerDate: August 6, 2004
    By:
    /s/ PHILLIP A. REINSCHPhillip A. ReinschSenior Vice President and
Chief Financial Officer -34-