##### Table of Contents



UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 FORM 10-Q x
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934For the quarterly period ended: September 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
    
    75-2027937(State or other jurisdiction of
    
    (I.R.S. Employerincorporation or organization)
    
    Identification No.)8401 North Central Expressway, Suite 800, Dallas, TX
    
    75225(Address of principal executive offices)
    
    (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  x   NO   o Indicate by check mark whether the Registrant is an m 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)
    
    17,677,180 as of October 29, 2004




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CAPSTEAD MORTGAGE CORPORATION
FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2004 INDEX PagePART I.  FINANCIAL INFORMATIONITEM 1. Financial StatementsConsolidated Balance Sheets  September 30, 2004 and December 31, 2003
    
    
    3Consolidated Statements of Operations  Quarter and Nine Months Ended
September 30, 2004 and 2003
    
    
    4Consolidated Statements of Cash Flows  Nine Months Ended September 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
    
    
    34ITEM 4. Controls and Procedures
    
    
    34PART II.  OTHER INFORMATIONITEM 6. Exhibits and Reports on Form 8-K
    
    
    34SIGNATURES
    
    
    35Computation of Ratio of Earnings to Combined Fixed ChargesCertification Pursuant to Section 302(a)Certification Pursuant to Section 302(a)Certification 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)
 September 30, 2004
    
    December 31, 2003(unaudited)
    
    (NOTE 2)AssetsMortgage securities and similar investments
($2.9 billion pledged under repurchase arrangements in 2004)
    
    $
    3,033,099
    
    
    $
    2,195,117CMO collateral and investments
    
    
    64,725
    
    
    
    167,5713,097,824
    
    
    
    2,362,688Real estate held for lease, net of accumulated depreciation
    
    
    130,632
    
    
    
    133,414Receivables and other assets
    
    
    47,391
    
    
    
    41,880Cash and cash equivalents
    
    
    8,096
    
    
    
    16,340$
    3,283,943
    
    
    $
    2,554,322LiabilitiesRepurchase arrangements and similar borrowings
    
    $
    2,766,669
    
    
    $
    1,975,178Collateralized mortgage obligations (CMOs)
    
    
    64,165
    
    
    
    166,807Borrowings secured by real estate
    
    
    120,052
    
    
    
    120,206Common stock dividend payable
    
    
    5,814
    
    
    
    8,829Accounts payable and accrued expenses
    
    
    7,142
    
    
    
    6,2642,963,842
    
    
    
    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
September 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
September 30, 2004 and December 31, 2003
($180,025 aggregate liquidation preference)
    
    
    176,705
    
    
    
    176,707Common stock - $0.01 par value; 100,000 shares authorized;
17,618 and 14,015 shares issued and outstanding at
September 30, 2004 and December 31, 2003, respectively
    
    
    176
    
    
    
    140Paid-in capital
    
    
    503,944
    
    
    
    456,198Accumulated deficit
    
    
    (387,718
    )
    
    
    (387,718
    )Accumulated other comprehensive income
    
    
    24,167
    
    
    
    28,755320,101
    
    
    
    277,038$
    3,283,943
    
    
    $
    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
    
    Nine Months EndedSeptember 30
    
    September 302004
    
    2003
    
    2004
    
    2003Interest income:Mortgage securities and similar investments
    
    $
    20,321
    
    
    $
    19,599
    
    
    $
    59,037
    
    
    $
    66,384CMO collateral and investments
    
    
    1,367
    
    
    
    5,971
    
    
    
    5,740
    
    
    
    31,061Total interest income
    
    
    21,688
    
    
    
    25,570
    
    
    
    64,777
    
    
    
    97,445Interest and related expense:Repurchase arrangements and similar borrowings
    
    
    10,079
    
    
    
    5,377
    
    
    
    22,876
    
    
    
    19,050CMO borrowings
    
    
    1,187
    
    
    
    5,803
    
    
    
    5,139
    
    
    
    31,152Mortgage insurance and other
    
    
    60
    
    
    
    93
    
    
    
    175
    
    
    
    301Total interest and related expense
    
    
    11,326
    
    
    
    11,273
    
    
    
    28,190
    
    
    
    50,503Net margin on financial assets
    
    
    10,362
    
    
    
    14,297
    
    
    
    36,587
    
    
    
    46,942Real estate lease income
    
    
    2,535
    
    
    
    2,468
    
    
    
    7,494
    
    
    
    7,564Real estate-related expense:Interest
    
    
    1,107
    
    
    
    1,046
    
    
    
    3,253
    
    
    
    3,271Depreciation
    
    
    927
    
    
    
    927
    
    
    
    2,781
    
    
    
    2,781Total real estate-related expense
    
    
    2,034
    
    
    
    1,973
    
    
    
    6,034
    
    
    
    6,052Net margin on real estate held for lease
    
    
    501
    
    
    
    495
    
    
    
    1,460
    
    
    
    1,512Other revenue (expense):Gain on asset sales and CMO redemptions
    
    
    
    
    
    
    1,411
    
    
    
    
    
    
    
    4,551CMO administration and other
    
    
    200
    
    
    
    459
    
    
    
    516
    
    
    
    860Incentive fee payable to former affiliate
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (500
    )Other operating expense
    
    
    (1,576
    )
    
    
    (1,883
    )
    
    
    (4,907
    )
    
    
    (5,802
    )Total other revenue (expense)
    
    
    (1,376
    )
    
    
    (13
    )
    
    
    (4,391
    )
    
    
    (891
    )Net income
    
    $
    9,487
    
    
    $
    14,779
    
    
    $
    33,656
    
    
    $
    47,563Net income
    
    $
    9,487
    
    
    $
    14,779
    
    
    $
    33,656
    
    
    $
    47,563Less cash dividends paid on preferred shares
    
    
    (5,064
    )
    
    
    (5,068
    )
    
    
    (15,195
    )
    
    
    (15,204
    )Net income available to common stockholders
    
    $
    4,423
    
    
    $
    9,711
    
    
    $
    18,461
    
    
    $
    32,359Net income per common share:Basic
    
    $
    0.27
    
    
    $
    0.69
    
    
    $
    1.20
    
    
    $
    2.32Diluted
    
    
    0.27
    
    
    
    0.63
    
    
    
    1.19
    
    
    
    2.04Cash dividends declared per share:Common
    
    $
    0.330
    
    
    $
    0.750
    
    
    $
    1.360
    
    
    $
    2.470Series A Preferred
    
    
    0.400
    
    
    
    0.400
    
    
    
    1.200
    
    
    
    1.200Series B Preferred
    
    
    0.315
    
    
    
    0.315
    
    
    
    0.945
    
    
    
    0.945
 See accompanying notes to consolidated financial statements. -4-




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CAPSTEAD MORTGAGE CORPORATION 
 CONSOLIDATED STATEMENTS OF CASH FLOWS
 (In thousands)
(Unaudited)
 Nine Months EndedSeptember 302004
    
    2003Operating activities:Net income
    
    $
    33,656
    
    
    $
    47,563Noncash items:Amortization of discount and premium
    
    
    10,071
    
    
    
    9,185Depreciation and other amortization
    
    
    3,283
    
    
    
    3,740Recognition of rent abatement
    
    
    128
    
    
    
    58Gain on asset sales and CMO redemptions
    
    
    
    
    
    
    (4,551
    )Change in incentive fee payable to former affiliate
    
    
    
    
    
    
    (4,982
    )Net change in receivables, other assets,
accounts payable and accrued expenses
    
    
    (419
    )
    
    
    (2,406
    )Net cash provided by operating activities
    
    
    46,719
    
    
    
    48,607Investing activities:Purchases of mortgage securities and similar investments
    
    
    (1,474,723
    )
    
    
    (235,028
    )Principal collections on mortgage securities
and similar investments
    
    
    616,953
    
    
    
    645,199Proceeds from asset sales
    
    
    
    
    
    
    123,543CMO collateral:Principal collections
    
    
    101,372
    
    
    
    594,113Decrease in accrued interest receivable
    
    
    636
    
    
    
    3,382Net cash provided by (used in) investing activities
    
    
    (755,762
    )
    
    
    1,131,209Financing activities:Net increase (decrease) in repurchase arrangements
and similar borrowings
    
    
    791,491
    
    
    
    (151,267
    )Principal payments on borrowings secured by real estate
    
    
    (154
    )
    
    
    (147
    )CMO borrowings:Principal payments on securities
    
    
    (100,824
    )
    
    
    (829,111
    )Decrease in accrued interest payable
    
    
    (603
    )
    
    
    (4,487
    )Capital stock transactions
    
    
    50,714
    
    
    
    70Dividends paid
    
    
    (39,825
    )
    
    
    (155,852
    )Net cash provided by (used in) financing activities
    
    
    700,799
    
    
    
    (1,140,794
    )Net change in cash and cash equivalents
    
    
    (8,244
    )
    
    
    39,022Cash and cash equivalents at beginning of period
    
    
    16,340
    
    
    
    59,003Cash and cash equivalents at end of period
    
    $
    8,096
    
    
    $
    98,025
 See accompanying notes to consolidated financial statements. -5-




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CAPSTEAD MORTGAGE CORPORATION 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 SEPTEMBER 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 and the relationship between
short- and long-term interest rates (the yield curve). With the flattening
of the yield curve experienced thus far in 2004, primarily due to higher
short-term interest rates, financing spreads (the difference between yields
earned on these investments and rates charged on related borrowings) have
declined from historically wide levels achieved the last several years when
short-term interest rates were declining. Because the majority of the
Companys financial assets currently consist of ARM securities backed by
mortgage loans with coupon interest rates that reset at least annually,
management believes the Company is well positioned to withstand the currently
anticipated higher interest rate environment. 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 nine months ended
September 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 nine months ended September 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
    
    Nine Months EndedSeptember 30
    
    September 302004
    
    2003
    
    2004
    
    2003Numerator for basic net income per common share:Net income
    
    $
    9,487
    
    
    $
    14,779
    
    
    $
    33,656
    
    
    $
    47,563Less all preferred share dividends
    
    
    (5,064
    )
    
    
    (5,068
    )
    
    
    (15,195
    )
    
    
    (15,204
    )Net income available to common stockholders
    
    $
    4,423
    
    
    $
    9,711
    
    
    $
    18,461
    
    
    $
    32,359Weighted average common shares outstanding
    
    
    16,645
    
    
    
    13,995
    
    
    
    15,387
    
    
    
    13,969Basic net income per common share
    
    $
    0.27
    
    
    $
    0.69
    
    
    $
    1.20
    
    
    $
    2.32Numerator for diluted net income per common share:Net income
    
    $
    9,487
    
    
    $
    14,779
    
    
    $
    33,656
    
    
    $
    47,563Less dividends on antidilutive preferred shares
    
    
    (5,064
    )
    
    
    
    
    
    
    (14,949
    )
    
    
    $
    4,423
    
    
    $
    14,779
    
    
    $
    18,707
    
    
    $
    47,563Denominator for diluted net income per common
share:Weighted average common shares outstanding
    
    
    16,645
    
    
    
    13,995
    
    
    
    15,387
    
    
    
    13,969Net effect of dilutive securities:Stock options
    
    
    25
    
    
    
    38
    
    
    
    33
    
    
    
    35Series A preferred shares
    
    
    
    
    
    
    315
    
    
    
    309
    
    
    
    316Series B preferred shares
    
    
    
    
    
    
    8,987
    
    
    
    
    
    
    
    8,94716,670
    
    
    
    23,335
    
    
    
    15,729
    
    
    
    23,267Diluted net income per common share
    
    $
    0.27
    
    
    $
    0.63
    
    
    $
    1.19
    
    
    $
    2.04
 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 September 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 September 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 generally are mortgage securities backed by mortgage
loans that have fixed rates of interest over the life of the loans.
Adjustable-rate investments generally are mortgage securities backed by
mortgage loans that have interest rates that adjust at least annually to more
current interest rates (current-reset ARM securities) or begin doing so after
an initial fixed-rate period (longer-to-reset ARM securities). Mortgage
loans underlying current-reset ARM securities either (i) adjust annually based
on a specified margin over the one-year Constant Maturity U.S. Treasury Note
Rate (CMT) or the one-year London Interbank Offered Rate (LIBOR), (ii)
adjust semiannually based on a specified margin over six-month LIBOR, or (iii)
adjust monthly based on a specific margin over an index such as LIBOR or the
Eleventh District Federal Reserve Bank Cost of Funds Index (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. Mortgage
loans underlying longer-to-reset ARM securities have initial fixed rates of
interest of three to ten years before beginning to adjust in rate as described
above. The average period until initial reset for the $283 million in
longer-to-reset ARM securities held by the Company as of September 30, 2004 was
20 months compared to less than 7 months to the next reset date for the
Companys current-reset ARM securities. CMBS held as of September 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)September 30, 2004Agency Securities:Fannie Mae/Freddie Mac:Fixed-rate
    
    $
    39,867
    
    
    $
    167
    
    
    $
    40,034
    
    
    $
    40,096
    
    
    
    6.64
    %
    
    
    6.11
    %ARMs
    
    
    1,716,039
    
    
    
    29,027
    
    
    
    1,745,066
    
    
    
    1,763,371
    
    
    
    3.69
    
    
    
    2.78Ginnie Mae ARMs
    
    
    1,065,463
    
    
    
    9,225
    
    
    
    1,074,688
    
    
    
    1,079,551
    
    
    
    4.00
    
    
    
    3.052,821,369
    
    
    
    38,419
    
    
    
    2,859,788
    
    
    
    2,883,018
    
    
    
    3.85
    
    
    
    2.95Non-agency Securities:Fixed-rate
    
    
    37,566
    
    
    
    40
    
    
    
    37,606
    
    
    
    37,680
    
    
    
    6.78
    
    
    
    6.26ARMs
    
    
    59,711
    
    
    
    755
    
    
    
    60,466
    
    
    
    61,029
    
    
    
    3.95
    
    
    
    3.2897,277
    
    
    
    795
    
    
    
    98,072
    
    
    
    98,709
    
    
    
    5.04
    
    
    
    4.42CMBS
    
    
    51,316
    
    
    
    11
    
    
    
    51,327
    
    
    
    51,372
    
    
    
    2.81
    
    
    
    2.61$
    2,969,962
    
    
    $
    39,225
    
    
    $
    3,009,187
    
    
    $
    3,033,099
    
    
    
    3.87
    
    
    
    3.00December 31, 2003Agency Securities:Fannie Mae/Freddie Mac:Fixed-rate
    
    $
    2,072
    
    
    $
    12
    
    
    $
    2,084
    
    
    $
    2,160
    
    
    
    10.00
    %
    
    
    9.38
    %ARMs
    
    
    1,141,430
    
    
    
    13,003
    
    
    
    1,154,433
    
    
    
    1,176,058
    
    
    
    3.66
    
    
    
    3.69Ginnie Mae ARMs
    
    
    726,876
    
    
    
    7,830
    
    
    
    734,706
    
    
    
    739,987
    
    
    
    4.27
    
    
    
    4.101,870,378
    
    
    
    20,845
    
    
    
    1,891,223
    
    
    
    1,918,205
    
    
    
    3.90
    
    
    
    3.88Non-agency Securities:Fixed-rate
    
    
    118,638
    
    
    
    174
    
    
    
    118,812
    
    
    
    118,812
    
    
    
    6.66
    
    
    
    6.25ARMs
    
    
    81,425
    
    
    
    1,293
    
    
    
    82,718
    
    
    
    83,724
    
    
    
    4.42
    
    
    
    3.64200,063
    
    
    
    1,467
    
    
    
    201,530
    
    
    
    202,536
    
    
    
    5.75
    
    
    
    4.63CMBS and commercial loans
    
    
    74,376
    
    
    
    (9
    )
    
    
    74,367
    
    
    
    74,376
    
    
    
    2.21
    
    
    
    4.44$
    2,144,817
    
    
    $
    22,303
    
    
    $
    2,167,120
    
    
    $
    2,195,117
    
    
    
    4.02
    
    
    
    3.97
  (a)
    
    Includes 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 these 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): September 30, 2004
    
    December 31, 2003Pledged CMO Collateral:Pledged Non-agency Securities
    
    $
    63,372
    
    
    $
    164,891Accrued interest receivable
    
    
    454
    
    
    
    1,08563,826
    
    
    
    165,976Unamortized premium
    
    
    899
    
    
    
    1,595$
    64,725
    
    
    $
    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 6.07% during the quarter ended September 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. 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 September 30, 2004 are $3.0 million in unamortized rent abatements
and $1.2 million of rent and other receivables due from Brookdale. -9-




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##### Table of Contents



Carrying amounts of the Properties were as follows (in thousands): September 30, 2004
    
    December 31, 2003Land
    
    $
    16,450
    
    
    $
    16,450Buildings
    
    
    119,550
    
    
    
    119,550Equipment and fixtures
    
    
    3,600
    
    
    
    3,600139,600
    
    
    
    139,600Accumulated depreciation
    
    
    (8,968
    )
    
    
    (6,186
    )$
    130,632
    
    
    $
    133,414
 NOTE 7  REPURCHASE ARRANGEMENTS AND SIMILAR BORROWINGS Capstead borrows under uncommitted repurchase arrangements with
well-established investment banking firms. Repurchase arrangements pursuant to
which the Company pledges Agency and Non-agency Securities as collateral
generally have maturities of less than 31 days, although during recent quarters
the Company extended maturities for up to two years on a portion of its
borrowings related to the Companys modest position in fixed-rate and
longer-to-reset ARM securities. Repurchase arrangements with CMBS pledged as
collateral generally have longer initial maturities and may feature renewal
options. From time-to-time the Company may acquire financial assets that are
not mortgage-backed securities and obtain similar borrowings from other
parties, such as commercial banks. 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): September 30, 2004
    
    December 31, 2003Borrowings
    
    Average
    
    Borrowings
    
    AverageOutstanding
    
    Rate
    
    Outstanding
    
    RateRepurchase arrangements:Agency Securities (less than 31 days)
    
    $
    2,227,922
    
    
    
    1.76
    %
    
    $
    1,735,027
    
    
    
    1.09
    %Agency Securities (greater than 90 days)
    
    
    412,829
    
    
    
    2.20
    
    
    
    
    
    
    
    Non-agency Securities (less than 31
days)
    
    
    77,404
    
    
    
    2.18
    
    
    
    170,205
    
    
    
    1.57CMBS (less than 31 days)
    
    
    
    
    
    
    
    
    
    
    20,300
    
    
    
    1.36CMBS (31 to 90 days)
    
    
    48,514
    
    
    
    1.91
    
    
    
    
    
    
    
    CMBS (greater than 90 days)
    
    
    
    
    
    
    
    
    
    
    49,646
    
    
    
    1.34$
    2,766,669
    
    
    
    1.84
    
    
    $
    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): September 30, 2004
    
    December 31, 2003CMOs
    
    $
    63,015
    
    
    $
    164,388Accrued interest payable
    
    
    335
    
    
    
    938Total obligation
    
    
    63,350
    
    
    
    165,326Unamortized premium
    
    
    815
    
    
    
    1,481$
    64,165
    
    
    $
    166,807Range of average interest rates
    
    2.20% to 9.53%
    
    1.50% to 9.42%Range of stated maturities
    
    
    2025 to 2030
    
    
    
    2025 to 2030Number of series
    
    
    5
    
    
    
    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 5.27%
during the quarter ended September 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): September 30, 2004
    
    December 31, 2003Borrowings
    
    Average
    
    Borrowings
    
    AverageOutstanding
    
    Rate
    
    Outstanding
    
    RateMortgage borrowings
    
    $
    19,211
    
    
    
    7.92
    %
    
    $
    19,365
    
    
    
    7.92
    %Tax-exempt bonds
    
    
    100,841
    
    
    
    2.87
    
    
    
    100,841
    
    
    
    2.54$
    120,052
    
    
    
    3.67
    
    
    $
    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 $89,000 at September 30, 2004 and are included in
Receivables and other assets.Monthly interest rate cap and principal reserve
fund payments are made to the trustee for the purchase of new cap agreements in
2007 and the eventual retirement of the bonds by 2032. 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 $2.4 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 3.65% for the
quarter ended September 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
mortgage prepayment rates 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 September 30, 2004Agency Securities:Fixed-rate
    
    $
    684
    
    
    $
    62
    
    
    $
    
    
    
    $
    746ARMs
    
    
    2,819,754
    
    
    
    25,243
    
    
    
    2,075
    
    
    
    2,842,9222,820,438
    
    
    
    25,305
    
    
    
    2,075
    
    
    
    2,843,668Non-agency Securities:Fixed-rate
    
    
    1,054
    
    
    
    74
    
    
    
    
    
    
    
    1,128ARMs
    
    
    43,001
    
    
    
    579
    
    
    
    16
    
    
    
    43,56444,055
    
    
    
    653
    
    
    
    16
    
    
    
    44,692CMBS
    
    
    51,327
    
    
    
    45
    
    
    
    
    
    
    
    51,372Pledged CMO collateral
    
    
    13,186
    
    
    
    357
    
    
    
    
    
    
    
    13,543$
    2,929,006
    
    
    $
    26,360
    
    
    $
    2,091
    
    
    $
    2,953,275As 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 ARM Securities
    
    
    58,613
    
    
    
    1,009
    
    
    
    3
    
    
    
    59,619CMBS
    
    
    74,367
    
    
    
    24
    
    
    
    15
    
    
    
    74,376Pledged CMO collateral
    
    
    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 related CMO indentures pursuant to Clean-up Calls and
held as Agency 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 September 30, 2004Released CMO Collateral:Agency Securities - fixed-rate
    
    $
    39,350
    
    
    $
    1,938
    
    
    $
    
    
    
    $
    41,288Non-agency Securities:Fixed-rate
    
    
    36,552
    
    
    
    1,370
    
    
    
    
    
    
    
    37,922ARMs
    
    
    17,465
    
    
    
    108
    
    
    
    147
    
    
    
    17,42693,367
    
    
    
    3,416
    
    
    
    147
    
    
    
    96,636Pledged CMO Collateral
    
    
    51,182
    
    
    
    141
    
    
    
    
    
    
    
    51,323$
    144,549
    
    
    $
    3,557
    
    
    $
    147
    
    
    $
    147,959
 -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
    
    Nine Months EndedSeptember 30
    
    September 302004
    
    2003
    
    2004
    
    2003Sale of securities held available-for-sale:Amortized cost
    
    $
    
    
    
    $
    12,305
    
    
    $
    
    
    
    $
    63,053Gain
    
    
    
    
    
    
    183
    
    
    
    
    
    
    
    2,014Sale of released CMO collateral
held-to-maturity:Amortized cost
    
    
    
    
    
    
    33,964
    
    
    
    
    
    
    
    56,720Gain
    
    
    
    
    
    
    1,037
    
    
    
    
    
    
    
    1,846
 NOTE 11  COMPREHENSIVE INCOME Comprehensive income is net income plus other comprehensive income (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 (in
thousands): Quarter Ended
    
    Nine Months EndedSeptember 30
    
    September 302004
    
    2003
    
    2004
    
    2003Net income
    
    $
    9,487
    
    
    $
    14,779
    
    
    $
    33,656
    
    
    $
    47,563Other comprehensive income (loss):Unrealized loss on derivative financial
instruments held as cash flow hedges:Change in unrealized loss during period
    
    
    (50
    )
    
    
    85
    
    
    
    (228
    )
    
    
    (184
    )Reclassification adjustment for amounts
included in net income
    
    
    (52
    )
    
    
    (40
    )
    
    
    (133
    )
    
    
    (77
    )(102
    )
    
    
    45
    
    
    
    (361
    )
    
    
    (261
    )Unrealized gain on debt securities:Change in unrealized gain during period
    
    
    7,218
    
    
    
    (9,983
    )
    
    
    (4,227
    )
    
    
    (11,921
    )Reclassification adjustment for gain
included in net income
    
    
    
    
    
    
    (183
    )
    
    
    
    
    
    
    (2,014
    )Other comprehensive income (loss)
    
    
    7,116
    
    
    
    (10,121
    )
    
    
    (4,588
    )
    
    
    (14,196
    )Comprehensive income
    
    $
    16,603
    
    
    $
    4,658
    
    
    $
    29,068
    
    
    $
    33,367
 -13-




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##### Table of Contents



NOTE 12   RESULTS OF CAPITAL RAISING ACTIVITY Between February 2, 2004 and September 27, 2004 the Company sold common shares
into the open market on a limited basis, resulting in the issuance of 3,563,100
common shares and increasing common shares outstanding to 17,617,680 by
September 30, 2004. Such sales resumed October 22, 2004 and may continue
throughout the fourth quarter if market conditions allow. As of quarter-end,
Capstead raised over $50 million of new common equity with these sales at an
average price of $14.11 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 September 302004
    
    2003Average
    
    
    
    
    
    AverageAmount
    
    Rate
    
    Amount
    
    RateInterest income:Mortgage securities and other investments
    
    $
    20,321
    
    
    
    3.00
    %
    
    $
    19,599
    
    
    
    3.82
    %CMO collateral and investments
    
    
    1,367
    
    
    
    6.07
    
    
    
    5,971
    
    
    
    5.99Total interest income
    
    
    21,688
    
    
    
    
    
    
    
    25,570Interest expense:Repurchase arrangements and similar
borrowings
    
    
    10,079
    
    
    
    1.58
    
    
    
    5,377
    
    
    
    1.13CMO borrowings
    
    
    1,187
    
    
    
    5.27
    
    
    
    5,803
    
    
    
    5.62Total interest expense
    
    
    11,266
    
    
    
    
    
    
    
    11,180$
    10,422
    
    
    
    
    
    
    $
    14,390
 Nine Months Ended September 302004
    
    2003Average
    
    
    
    
    
    AverageAmount
    
    Rate
    
    Amount
    
    RateInterest income:Mortgage securities and similar investments
    
    $
    59,037
    
    
    
    3.16
    %
    
    $
    66,384
    
    
    
    4.09
    %CMO collateral and investments
    
    
    5,740
    
    
    
    6.43
    
    
    
    31,061
    
    
    
    6.26Total interest income
    
    
    64,777
    
    
    
    
    
    
    
    97,445Interest expense:Repurchase arrangements and similar
borrowings
    
    
    22,876
    
    
    
    1.31
    
    
    
    19,050
    
    
    
    1.26CMOs borrowings
    
    
    5,139
    
    
    
    5.76
    
    
    
    31,152
    
    
    
    6.24Total interest expense
    
    
    28,015
    
    
    
    
    
    
    
    50,202$
    36,762
    
    
    
    
    
    
    $
    47,243
 -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 September 30, 2004Rate*
    
    Volume*
    
    TotalInterest income:Mortgage securities and similar investments
    
    $
    (4,738
    )
    
    $
    5,460
    
    
    $
    722CMO collateral and investments
    
    
    77
    
    
    
    (4,681
    )
    
    
    (4,604
    )Total interest income
    
    
    (4,661
    )
    
    
    779
    
    
    
    (3,882
    )Interest expense:Repurchase arrangements and similar
borrowings
    
    
    2,553
    
    
    
    2,149
    
    
    
    4,702CMOs
    
    
    (343
    )
    
    
    (4,273
    )
    
    
    (4,616
    )Total interest expense
    
    
    2,210
    
    
    
    (2,124
    )
    
    
    86$
    (6,871
    )
    
    $
    2,903
    
    
    $
    (3,968
    )
 Nine Months Ended September 30, 2004Rate*
    
    Volume*
    
    TotalInterest income:Mortgage securities and similar investments
    
    $
    (16,367
    )
    
    $
    9,020
    
    
    $
    (7,347
    )CMO collateral and investments
    
    
    802
    
    
    
    (26,123
    )
    
    
    (25,321
    )Total interest income
    
    
    (15,565
    )
    
    
    (17,103
    )
    
    
    (32,668
    )Interest expense:Repurchase arrangements and similar
borrowings
    
    
    766
    
    
    
    3,060
    
    
    
    3,826CMOs
    
    
    (2,216
    )
    
    
    (23,797
    )
    
    
    (26,013
    )Total interest expense
    
    
    (1,450
    )
    
    
    (20,737
    )
    
    
    (22,187
    )$
    (14,115
    )
    
    $
    3,634
    
    
    $
    (10,481
    )
  *
    
    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
2003s Other operating expenseis $210,000 of base fees paid to Fortress for
services rendered through termination. 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 nine months of 2004 such
that the Company was successful in growing the mortgage securities and similar
investments portfolio to over $3.0 billion at September 30, 2004 from $2.2
billion at year end. The Company intends to continue pursuing the acquisition
of attractively priced ARM securities, while also investigating other real
estate-related opportunities. Beginning June 30, 2004, in response to current growth prospects for the United
States economy, the Federal Reserves Federal Open Market Committee (the
Federal Reserve) has acted to increase short-term interest rates by raising
the federal funds rate 25 basis points at each of its last three meetings and
is expected to act further to increase rates at future meetings. Higher
short-term interest rates are increasing 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). The effects of
rising borrowing costs on financing spreads can eventually be mitigated by ARM
security yield increases. However, interest rates on the Companys borrowings
rise (and fall) almost immediately while ARM security yields change slowly by
comparison because the coupon interest rates on the underlying loans generally
reset only once 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 may decline in the immediately
ensuing quarters before the benefits of ARM security yield increases are fully
realized. Risk Factors and Critical Accounting Policies Under the captions Effects of Interest Changes, Risks Associated with
Credit-Sensitive Investments, Risks Associated with Owning Real Estate,
Regulatory Matters and Critical Accounting Policies are discussions of risk
factors and critical accounting policies affecting Capsteads financial
condition and results of operations that are an integral part of this
discussion and analysis. Readers are strongly urged to consider the potential
impact of these factors and accounting policies on the Company while reading
this document. -16-




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##### Table of Contents



Results of Capital Raising Activity Between February 2, 2004 and September 27, 2004 the Company sold common shares
into the open market on a limited basis, resulting in the issuance of 3,563,100
common shares and increasing common shares outstanding to 17,617,680 by
September 30, 2004. Such sales resumed October 22, 2004 and may continue
throughout the fourth quarter, if market conditions allow. As of quarter-end,
Capstead raised over $50 million of new common equity with these sales at an
average price of $14.11 per share, after expenses. The proceeds from these
issuances have been invested in attractively-priced ARM securities. Book Value per Common Share As of September 30, 2004, the Companys book value per common share was $7.76,
an increase of $1.09 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 declines in the aggregate unrealized gain on the
Companys investments, primarily as a result of portfolio runoff, and dividend
payments in excess of GAAP net income. Common stock issuances contributed
$1.52 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 $0.25
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, lowered book value by $0.18 per share. The unrealized
gain on the Companys investments 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 balance sheet generally will not affect book
value. Mortgage Securities and Similar Investments As of September 30, 2004, the mortgage securities and similar investments
portfolio consisted primarily of ARM Agency Securities. ARM securities held by
the Company are backed by mortgage loans that have interest rates that adjust
at least annually to more current interest rates (current-reset ARM
securities) or begin doing so after an initial fixed-rate period
(longer-to-reset ARM securities). Longer-to-reset ARM securities represented
approximately 9% of the total portfolio as of September 30, 2004. 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 September 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 nine months ended September 30, 2004 to over $3.0 billion from $2.2 billion
at December 31, 2003, representing the fifth straight quarter of portfolio
growth after several years of declines. Acquisitions during the quarter and
nine months ended September 30, 2004 totaled $672 million and $1.4 billion,
respectively, consisting almost exclusively of ARM Agency Securities. Runoff
caused by mortgage prepayments remains a -17-




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##### Table of Contents



challenge to earnings generated by the Companys mortgage securities. Runoff
during the third quarter totaled $267 million, higher than the $202 million
experienced during the second quarter of 2004 and the $148 million incurred
during the first quarter of 2004. Runoff was higher during the third quarter
in part due to higher portfolio balances, but also because of persistently high
levels of mortgage prepayments. Given the current relatively low mortgage
interest rate environment, mortgage prepayment rates are expected to remain at
elevated levels during the fourth quarter. The Company has had continued success subsequent to quarter-end acquiring
additional ARM securities such that it expects further portfolio growth during
the fourth quarter of 2004; however, there can be no assurance that
attractively priced ARM securities will continue to be available. If the
proceeds of runoff 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. The following yield and cost analysis illustrates results achieved during the
third quarter of 2004 for components of the mortgage securities and similar
investments portfolio and anticipated fourth quarter 2004 asset yields and
borrowing rates (dollars in thousands): 3rd Quarter Average (a)
    
    As of September 30, 2004
    
    Projected
    
    LifetimeActual
    
    Actual
    
    Premiums
    
    
    
    
    
    4th Quarter
    
    RunoffBasis
    
    Yield/Cost
    
    Runoff
    
    (Discounts)
    
    Basis(a)
    
    Yield/Cost(b)
    
    AssumptionsAgency Securities:Fannie Mae/Freddie
Mac:Fixed-rate
    
    $
    43,262
    
    
    
    6.11
    %
    
    
    43
    %
    
    $
    167
    
    
    $
    40,034
    
    
    
    6.26
    %
    
    
    39
    %ARMs
    
    
    1,460,360
    
    
    
    2.78
    
    
    
    34
    
    
    
    29,027
    
    
    
    1,745,066
    
    
    
    3.05
    
    
    
    32Ginnie Mae ARMs
    
    
    1,038,813
    
    
    
    3.05
    
    
    
    28
    
    
    
    9,225
    
    
    
    1,074,688
    
    
    
    3.06
    
    
    
    292,542,435
    
    
    
    2.95
    
    
    
    32
    
    
    
    38,419
    
    
    
    2,859,788
    
    
    
    3.09
    
    
    
    31Non-agency Securities:Fixed-rate
    
    
    40,004
    
    
    
    6.26
    
    
    
    37
    
    
    
    40
    
    
    
    37,606
    
    
    
    6.36
    
    
    
    38ARMs
    
    
    64,533
    
    
    
    3.28
    
    
    
    32
    
    
    
    755
    
    
    
    60,466
    
    
    
    3.78
    
    
    
    37104,537
    
    
    
    4.42
    
    
    
    35
    
    
    
    795
    
    
    
    98,072
    
    
    
    4.76
    
    
    
    37CMBS
    
    
    54,680
    
    
    
    2.61
    
    
    
    34
    
    
    
    11
    
    
    
    51,327
    
    
    
    3.13
    
    
    
    12,701,652
    
    
    
    3.00
    
    
    
    34
    
    
    $
    39,225
    
    
    
    3,009,187
    
    
    
    3.14
    
    
    
    30Related borrowings:30-day LIBOR
    
    
    2,182,284
    
    
    
    1.49
    
    
    
    
    
    
    
    
    
    
    
    2,353,840
    
    
    
    1.96> 30-day LIBOR
    
    
    320,707
    
    
    
    2.20
    
    
    
    
    
    
    
    
    
    
    
    412,829
    
    
    
    2.242,502,991
    
    
    
    1.58
    
    
    
    
    
    
    
    
    
    
    
    2,766,669
    
    
    
    2.01Capital employed/
financing spread
    
    $
    198,661
    
    
    
    1.42
    
    
    
    
    
    
    
    
    
    
    $
    242,518
    
    
    
    1.13Return on assets (c)
    
    
    
    
    
    
    1.51
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1.25
  (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 fourth quarter of 2004 reflect
interest rates in effect on October 21, 2004 (the date third quarter 2004
results were released) as well as ARM coupon resets and lifetime runoff
assumptions as adjusted for expected acquisitions and runoff for this
quarter only. Actual yields realized in future periods will largely
depend upon (i) changes in portfolio composition, (ii) ARM coupon resets,
(iii) actual runoff and (iv) any changes in lifetime runoff assumptions.
Interest rates on borrowings that reset every 30 days at the 30-day London
Interbank offered Rate (LIBOR) reflect expectations for a 25 basis point
increase in the federal funds rate at the November 10, 2004 Federal
Reserve meeting and no change in the federal funds rate resulting from the
December 14, 2004 meeting.(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). -18-




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##### Table of Contents



Financing spreads declined 48 basis points during the third quarter of 2004 to
1.42%, attributable to lower mortgage investment yields and higher borrowing
costs. The overall yield earned on the portfolio averaged 3.00% during the
third quarter, compared to an average yield of 3.10% earned during the prior
quarter. Yields on ARM securities are affected by mortgage prepayment rates,
which have an impact on how quickly purchase premiums are amortized to earnings
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 prepayment rates and, to a
lesser extent, lower yielding additions to the portfolio. These factors more
than offset the benefit to yields from higher coupon interest rates on a
portion of the portfolios underlying mortgage loans that reset during the
current quarter. On average, coupon interest rate resets are expected to
continue trending higher contributing to improving portfolio yields in the
coming quarters. For example, if interest rates remain at rates in effect
October 21, 2004, the average yield on the existing portfolio could increase
approximately 61 basis points by the third quarter of 2005. Actual yields will
depend on portfolio composition as well as fluctuations in, and market
expectations for fluctuations in, interest rates and mortgage prepayment rates. Average rates on borrowings secured by mortgage investments increased 38 basis
points to 1.58% during the third quarter of 2004 compared to the prior quarter
and are expected to increase further in future quarters. The Federal Reserve
has acted to increase short-term interest rates by raising the federal funds
rate 25 basis points at each of its last three meetings and is expected to act
further to increase rates at future meetings in response to current growth
expectations for the United States economy. In response to these market
conditions, over the last two quarters the Company extended maturities for up
to two years on its borrowings related to the Companys modest position in
fixed-rate securities and longer-to-reset ARM securities. By doing so the
Company effectively locked in attractive financing spreads over the average
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 September
30, 2004, the Company holds Clean-up Call rights on only one of its five
remaining CMOs. Consequently, additional significant gains from CMO
redemptions are not expected to occur. CMO collateral and investments, net of
related bonds, was $560,000 at September 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, -19-




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##### Table of Contents



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
    )

    
    97.1
    %
    
    
    1987Chambrel at Pinecastle
    
    Ocala, FL
    
    161 (120 IL; 41 AL
    )

    
    98.8
    
    
    
    1987Chambrel at Island Lake
    
    Longwood, FL
    
    269 (229 IL; 40 AL
    )

    
    96.7
    
    
    
    1985Chambrel at Montrose
    
    Akron, OH
    
    168 (136 IL; 32 AL
    )

    
    96.4
    
    
    
    1987Chambrel at Williamsburg
    
    Williamsburg, VA
    
    255 (200 IL; 55 AL
    )

    
    98.8
    
    
    
    1987Chambrel at Club Hill
    
    Garland, TX
    
    260 (192 IL; 68 AL
    )

    
    90.4
    
    
    
    1987Total
    
    
    
    1,393  (1,133 IL; 260  AL
    )

    
    96.2
  (a)
    
    IL refers to independent living units. AL refers to assisted living units.(b)
    
    As of September 30, 2004. The Lease has an initial term of 20 years and provides for two 10-year renewal
periods. Beginning in May 2007, Brookdale will have the option of purchasing
all of the Properties from Capstead at the greater of fair value or Capsteads
original cost, after certain adjustments. Under the terms of the Lease,
Brookdale is responsible for paying all expenses associated with operating the
Properties, including real estate taxes, other government charges, insurance,
utilities and maintenance, and an amount representing an attractive cash return
on Capsteads equity in the Properties after payment of monthly debt service.
In keeping with Capsteads strategy of owning investments that can produce
attractive risk-adjusted returns over the long term with relatively low
sensitivity to changes in interest rates, changes in monthly debt service
requirements are the responsibility of Brookdale under the terms of the Lease. 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). Since year-end, Capstead has invested proceeds from portfolio runoff and
capital raising activities, and a portion of its already existing 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 $153 million at September 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. -20-




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##### Table of Contents



The following table illustrates Capsteads utilization of capital and potential liquidity as of September 30, 2004
in comparison with December 31, 2003 (in thousands): Capital
    
    PotentialAssets (a)
    
    Borrowings
    
    Employed
    
    Liquidity (a)Mortgage securities and similar
investments:Agency Securities
    
    $
    2,883,018
    
    
    $
    2,640,751
    
    
    $
    242,267
    
    
    $
    157,657Non-agency Securities
    
    
    98,709
    
    
    
    77,404
    
    
    
    21,305
    
    
    
    15,080CMBS
    
    
    51,372
    
    
    
    48,514
    
    
    
    2,858
    
    
    
    (68
    )3,033,099
    
    
    
    2,766,669
    
    
    
    266,430
    
    
    
    172,669CMO collateral and investments

    
    
    64,725
    
    
    
    64,165
    
    
    
    560
    
    
    
    Real estate held for lease
    
    
    130,632
    
    
    
    120,052
    
    
    
    10,580
    
    
    
    $
    3,228,456
    
    
    $
    2,950,886
    
    
    
    277,570
    
    
    
    172,669Other assets, net of other liabilities
    
    
    
    
    
    
    
    
    
    
    48,345
    
    
    
    8,096
    (b)Third quarter common dividend
    
    
    
    
    
    
    
    
    
    
    (5,814
    )
    
    
    (5,814
    )(c)Liquidity reserves for funding principal
payments and margin calls
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (153,000
    )$
    320,101
    
    
    $
    21,951Balances 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 September 30, 2004, adjusted separately for liquidity reserves.(b)
    
    Represents unrestricted cash and cash equivalents.(c)
    
    The third quarter 2004 common dividend was declared September 9, 2004 and paid October 21, 2004 to
stockholders of record as of September 30, 2004. -21-




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##### Table of Contents



RESULTS OF OPERATIONS Comparative net operating results (interest income or lease revenue, net of
related interest or depreciation expense) by source were as follows (in
thousands, except per share amounts): Quarter Ended
    
    Nine Months EndedSeptember 30
    
    September 302004
    
    2003
    
    2004
    
    2003Mortgage securities and similar investments:Agency Securities
    
    $
    9,285
    
    
    $
    11,476
    
    
    $
    32,114
    
    
    $
    40,457Non-agency Securities
    
    
    766
    
    
    
    1,974
    
    
    
    3,394
    
    
    
    4,048CMBS and other commercial loans
    
    
    146
    
    
    
    710
    
    
    
    508
    
    
    
    2,627CMO collateral and investments
    
    
    165
    
    
    
    137
    
    
    
    571
    
    
    
    (190
    )Net margin on financial assets
    
    
    10,362
    
    
    
    14,297
    
    
    
    36,587
    
    
    
    46,942Real estate held for lease:Lease revenue net of related interest
expense
    
    
    1,428
    
    
    
    1,422
    
    
    
    4,241
    
    
    
    4,293Real estate depreciation
    
    
    (927
    )
    
    
    (927
    )
    
    
    (2,781
    )
    
    
    (2,781
    )Net margin on real estate held for lease
    
    
    501
    
    
    
    495
    
    
    
    1,460
    
    
    
    1,512Other revenue (expense):Gain on asset sales and CMO redemptions
    
    
    
    
    
    
    1,411
    
    
    
    
    
    
    
    4,551CMO administration and other
    
    
    200
    
    
    
    459
    
    
    
    516
    
    
    
    860Incentive fee payable to former affiliate
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (500
    )Other operating expense
    
    
    (1,576
    )
    
    
    (1,883
    )
    
    
    (4,907
    )
    
    
    (5,802
    )Total other revenue (expense)
    
    
    (1,376
    )
    
    
    (13
    )
    
    
    (4,391
    )
    
    
    (891
    )Net income
    
    
    9,487
    
    
    
    14,779
    
    
    
    33,656
    
    
    
    47,563Less cash dividends on preferred shares
    
    
    (5,064
    )
    
    
    (5,068
    )
    
    
    (15,195
    )
    
    
    (15,204
    )Net income available to common stockholders
    
    $
    4,423
    
    
    $
    9,711
    
    
    $
    18,461
    
    
    $
    32,359Operating income *
    
    $
    5,431
    
    
    $
    9,313
    
    
    $
    21,488
    
    
    $
    30,845Weighted average shares outstanding:Basic
    
    
    16,645
    
    
    
    13,995
    
    
    
    15,387
    
    
    
    13,969Diluted
    
    
    16,670
    
    
    
    23,335
    
    
    
    15,729
    
    
    
    23,267Operating *
    
    
    16,973
    
    
    
    14,348
    
    
    
    15,729
    
    
    
    14,320Net income per common share:Basic
    
    $
    0.27
    
    
    $
    0.69
    
    
    $
    1.20
    
    
    $
    2.32Diluted
    
    
    0.27
    
    
    
    0.63
    
    
    
    1.19
    
    
    
    2.04Operating *
    
    
    0.32
    
    
    
    0.65
    
    
    
    1.37
    
    
    
    2.15Common dividends declared per share
    
    $
    0.33
    
    
    $
    0.75
    
    
    $
    1.36
    
    
    $
    2.47
  *
    
    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 $2.17 (the Series B preferred share
annualized dividend of $1.26 divided by the current conversion rate of
0.5810). Operating income per common share excludes the dilutive effects,
if present, of the Series B preferred shares because it is not
economically advantageous to convert these shares at market prices of both
the common shares and Series B preferred shares; therefore few, if any,
Series B preferred share conversions are expected. -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 shape and relative
position of 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 steadily
declining yields on the Companys adjustable-rate assets and relatively high
mortgage prepayment rates. This trend of declining asset yields continued into
the third quarter of 2004, resulting in additional pressure on net margins and
financing spreads during the first nine months of 2004 even as the Company was
successful in increasing the size of its mortgage securities and similar
investments portfolio. Short-term interest rates began increasing again in June 2004 in response to
Federal Reserve actions to raise short-term interest rates. These higher rates
resulted in significantly higher borrowing rates contributing to lower net
margins and financing spreads for the Company in the third quarter. This
illustrates how the Company is impacted immediately when short-term interest
rates rise (and fall) while ARM security yields change slowly in comparison
because coupon interest rates on the underlying mortgage loans generally reset
only once or twice a year. Even during the third quarter of 2004, coupon
resets began trending higher and the Company expects higher portfolio yields in
the coming quarters as this trend continues. Because the majority of Capsteads financial asset portfolios currently consist
of ARM securities, management believes Capstead is positioned to withstand the
anticipated higher interest rate environment, albeit at reduced financing
spreads and, therefore, at a reduced earnings level than that achieved the last
several years when short-term interest rates were declining. See Financial
Condition  Overview and Mortgage Securities and Similar Investments for
further discussion of the current operating environment. Key operating statistics for each component of the mortgage securities and
similar investments portfolio were as follows (dollars in millions): Quarter Ended
    
    Nine Months EndedSeptember 30
    
    September 302004
    
    2003
    
    2004
    
    2003Agency Securities:Yields
    
    
    2.95
    %
    
    
    3.69
    %
    
    
    3.10
    %
    
    
    4.02
    %Borrowing rates
    
    
    1.56
    
    
    
    1.06
    
    
    
    1.29
    
    
    
    1.21Financing spreads
    
    
    1.39
    
    
    
    2.63
    
    
    
    1.81
    
    
    
    2.81Average portfolio outstanding
    
    $
    2,542
    
    
    $
    1,737
    
    
    $
    2,281
    
    
    $
    1,895Runoff rates
    
    
    32
    %
    
    
    35
    %
    
    
    27
    %
    
    
    33
    %Non-agency Securities:Yields
    
    
    4.42
    %
    
    
    4.68
    %
    
    
    4.62
    %
    
    
    4.45
    %Borrowing rates
    
    
    1.84
    
    
    
    1.45
    
    
    
    1.58
    
    
    
    1.45Financing spreads
    
    
    2.58
    
    
    
    3.23
    
    
    
    3.04
    
    
    
    3.00Average portfolio outstanding
    
    $
    105
    
    
    $
    200
    
    
    $
    136
    
    
    $
    144Runoff rates
    
    
    35
    %
    
    
    47
    %
    
    
    38
    %
    
    
    37
    %CMBS and other commercial loans:Yields
    
    
    2.61
    %
    
    
    4.27
    %
    
    
    2.31
    %
    
    
    4.69
    %Borrowing rates
    
    
    1.66
    
    
    
    1.95
    
    
    
    1.39
    
    
    
    2.06Financing spreads
    
    
    0.95
    
    
    
    2.32
    
    
    
    0.92
    
    
    
    2.63Average portfolio outstanding
    
    $
    55
    
    
    $
    67
    
    
    $
    67
    
    
    $
    120Runoff rates
    
    
    34
    %
    
    
    2
    %
    
    
    13
    %
    
    
    21
    %
 -23-




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The Agency Securities portfolio remained the primary contributor to operating
results during the quarter and nine months ended September 30, 2004; however,
the impact of lower financing spreads was evident in current year results,
which were less than in the same periods in 2003 despite higher average
portfolios outstanding during 2004. The Non-Agency Securities portfolio
contributed less operating results during the quarter and nine months ended
September 30, 2004 primarily because of lower average portfolios outstanding
but results were also negatively affected by lower financing spreads. This
portfolio declined with runoff and the securitization and transfer of $53
million of high coupon fixed-rate Non-Agency Securities into Fannie Mae Agency
Securities in March 2004. CMBS and other commercial loans contributed
significantly less to operating results during the quarter and nine months
ended September 30, 2004 than in the same periods in 2003 due largely to
payoffs during 2003 of several higher yielding investments. 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. Having redeemed
over the past several years all but one of the 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 operating expense (including incentive fees payable to former affiliate)
were lower during the quarter and nine months ended September 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 September 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 $413 million of these borrowings during the second and third quarters (see
discussion above under Mortgage Securities and Similar Investments).
Borrowings secured by Agency Securities and Non-agency Securities totaled $2.7
billion at September 30, 2004. -24-




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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. 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 $49 million at
September 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 $64 million at September 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 fourth
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 other 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. -25-




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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. Capstead had the following estimated earnings sensitivity profile as of
September 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:September 30, 2004
    
    
    1.84
    %
    
    
    4.12
    %
    
    $
    (1,874
    )
    
    $
    (11,003
    )
    
    $
    (10,422
    )
    
    $
    (26,965
    )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 large part, on the difference between the
interest received on mortgage securities and similar investments, and the
interest paid on related borrowings, which are generally based on 30-day LIBOR.
The resulting financing spread may be reduced or even turn negative in a
rising short-term interest rate environment. Because the mortgage securities
and similar investments portfolio consists primarily of current-reset ARM
securities, the effects of rising short-term interest rates on borrowing costs
can eventually be mitigated by increases in the rates of interest earned on the
underlying ARM loans, which generally reset 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 and average months-to-roll (the average
number of months to coupon reset date) as of September 30, 2004 (dollars in
thousands): Average
    
    Average
    
    Average
    
    MonthsCoupon
    
    Periodic
    
    Lifetime
    
    ToARM Type
    
    Basis *
    
    Rate
    
    Cap
    
    Cap
    
    RollAgency Securities:Fannie Mae/Freddie Mac:Current-reset
    
    $
    1,462,204
    
    
    
    3.55
    %
    
    
    2.04
    %
    
    
    10.87
    %
    
    
    6.32Longer-to-reset
    
    
    282,862
    
    
    
    4.45
    
    
    
    2.47
    
    
    
    10.49
    
    
    
    19.82Ginnie Mae
    
    
    1,074,688
    
    
    
    4.00
    
    
    
    1.00
    
    
    
    10.00
    
    
    
    6.89Non-agency Securities
    
    
    60,466
    
    
    
    3.95
    
    
    
    1.73
    
    
    
    11.25
    
    
    
    5.18$
    2,880,220
    
    
    
    3.81
    
    
    
    1.69
    
    
    
    10.51
    
    
    
    7.84
  *
    
    Basis represents the Companys investment before unrealized gains and
losses. -26-




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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 second and third quarters on borrowings related to its modest
position of fixed-rate and longer-to-reset ARM securities) 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. 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, -27-




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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 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. -28-




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
    
    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.
    
    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. -29-




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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.  
    
    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. REGULATORY MATTERS Tax Status As used herein, Capstead REIT refers to Capstead and the entities that are
consolidated with Capstead for federal income tax purposes. Capstead REIT has
elected to be taxed as a REIT for federal income tax purposes and intends to
continue to do so. As a result of this election, Capstead REIT will not be
taxed at the corporate level on taxable income distributed to stockholders,
provided that certain requirements concerning the nature and composition of its
income and assets are met and that at least 90% of its REIT taxable income is
distributed. If Capstead REIT were to fail to qualify as a REIT in any taxable year, it
would be subject to federal income tax at regular corporate rates and would not
receive a deduction for dividends paid to stockholders. If this were the case,
the amount of after-tax income available for distribution to stockholders would
decrease substantially. As long as Capstead REIT qualifies as a REIT, it will
generally be taxable only on its undistributed taxable income. Distributions
out of current or accumulated taxable earnings and profits will be taxed to
stockholders as ordinary income or capital gain, as the case may be, and will
not qualify for the dividend tax rate reduction to 15% enacted as part of the
Jobs and Growth Tax Relief Act of 2002, except as discussed below.
Distributions in excess of Capstead REITs current or accumulated earnings and
profits will constitute a non-taxable return of capital to the stockholders
(except insofar as such distributions exceed the cost basis of the shares of
stock) resulting in a corresponding reduction in the cost basis of the shares
of stock. Distributions by the Company will not be eligible for the dividends
received deduction for corporations. Should the Company incur losses,
stockholders will not be entitled to include such losses in their individual
income tax returns. Capstead may find it advantageous from time-to-time to elect non-REIT
subsidiary status for certain of its subsidiaries. All taxable income of
Capsteads non-REIT subsidiaries, if any, is subject to federal and state
income taxes, where applicable. Capstead REITs taxable income will include
the income of its non-REIT subsidiaries only upon distribution of such income
to Capstead REIT, and only if these distributions are made out of current or
accumulated earnings and profits. Should this occur, a portion of Capsteads
distributions to its stockholders could qualify for the 15% dividend tax rate
provided by the Jobs and Growth Tax Relief Act of 2002. Investment Company Act of 1940 The Investment Company Act of 1940, as amended (the Investment Company Act),
exempts from regulation as an investment company any entity that is primarily
engaged in the business of purchasing or otherwise acquiring mortgages and
other liens on, and interests in, real estate. Capstead conducts its -30-




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business so as not to become regulated as an investment company. If it were to
be regulated as an investment company, Capsteads ability to use leverage would
be substantially reduced and it would be unable to conduct its business as
described herein. Under the current interpretation of the staff of the Securities and Exchange
Commission (SEC), in order to be exempted from regulation as an investment
company, a REIT must maintain at least 55% of its assets directly in qualifying
real estate interests. In satisfying this 55% requirement, a REIT may treat
mortgage-backed securities issued with respect to an underlying pool to which
it holds all issued certificates as qualifying real estate interests. If the
SEC or its staff adopts a contrary interpretation of such treatment, the REIT
could be required to sell a substantial amount of these securities or other
non-qualified assets under potentially adverse market conditions. CRITICAL ACCOUNTING POLICIES Managements discussion and analysis of financial condition and results of
operations is based upon Capsteads consolidated financial statements, which
have been prepared in accordance with accounting principles generally accepted
in the United States. The preparation of these financial statements requires
the use of estimates and judgments that can affect the reported amounts of
assets, liabilities (including contingencies), revenues and expenses as well as
related disclosures. These estimates are based on available internal and
market information and appropriate valuation methodologies believed to be
reasonable under the circumstances, the results of which form the basis for
making judgments about the expected useful lives and carrying values of assets
and liabilities which can materially affect the determination of net income and
book value per common share. Actual results may differ from these estimates
under different assumptions or conditions. Management believes the following are critical accounting policies in the
preparation of Capsteads consolidated financial statements that involve the
use of estimates requiring considerable judgment:  
    
    Amortization of Premiums and Discounts on Financial Assets and
Borrowings Premiums and discounts on financial assets and borrowings
are recognized in earnings as adjustments to interest income or
interest expense by the interest method over the estimated lives of
the related assets or borrowings. For most of Capsteads financial
assets, estimates and judgments related to future levels of mortgage
prepayments are critical to this determination (see Effects of
Interest Rate Changes).
    
    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 -31-




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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. -32-




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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 EndedSeptember 30, 2004
    
    September 30, 2003Operating
    
    Diluted
    
    Operating
    
    DilutedNet income
    
    $
    9,487
    
    
    $
    9,487
    
    
    $
    14,779
    
    
    $
    14,779Adjustments for:Depreciation on real estate
    
    
    927
    
    
    
    
    
    
    
    927
    
    
    
    Gain on asset sales and CMO redemptions
    
    
    
    
    
    
    
    
    
    
    (1,411
    )
    
    
    Dividends on antidilutive preferred
shares
    
    
    (4,983
    )
    
    
    (5,064
    )
    
    
    (4,982
    )
    
    
    $
    5,431
    
    
    $
    4,423
    
    
    $
    9,313
    
    
    $
    14,779Weighted average common shares
outstanding
    
    
    16,645
    
    
    
    16,645
    
    
    
    13,995
    
    
    
    13,995Net effect of dilutive securities:Stock options
    
    
    25
    
    
    
    25
    
    
    
    38
    
    
    
    38Preferred A shares
    
    
    303
    
    
    
    
    
    
    
    315
    
    
    
    315Preferred B shares
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    8,98716,973
    
    
    
    16,670
    
    
    
    14,348
    
    
    
    23,335$
    0.32
    
    
    $
    0.27
    
    
    $
    0.65
    
    
    $
    0.63
 Nine Months EndedSeptember 30, 2004
    
    September 30, 2003Operating
    
    Diluted
    
    Operating
    
    DilutedNet income
    
    $
    33,656
    
    
    $
    33,656
    
    
    $
    47,563
    
    
    $
    47,563Adjustments for:Depreciation on real estate
    
    
    2,781
    
    
    
    
    
    
    
    2,781
    
    
    
    Gain on asset sales and CMO redemptions
    
    
    
    
    
    
    
    
    
    
    (4,551
    )
    
    
    Dividends on antidilutive preferred
shares
    
    
    (14,949
    )
    
    
    (14,949
    )
    
    
    (14,948
    )
    
    
    $
    21,488
    
    
    $
    18,707
    
    
    $
    30,845
    
    
    $
    47,563Weighted average common shares
outstanding
    
    
    15,387
    
    
    
    15,387
    
    
    
    13,969
    
    
    
    13,969Net effect of dilutive securities:Stock options
    
    
    33
    
    
    
    33
    
    
    
    35
    
    
    
    35Preferred A shares
    
    
    309
    
    
    
    309
    
    
    
    316
    
    
    
    316Preferred B shares
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    8,94715,729
    
    
    
    15,729
    
    
    
    14,320
    
    
    
    23,267$
    1.37
    
    
    $
    1.19
    
    
    $
    2.15
    
    
    $
    2.04
 -33-




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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 September 30, 2004, an evaluation was performed under the supervision and
with the participation of the Companys management, including the Chief
Executive Officer (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 September 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 September 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 July 22, 2004 announcing second quarter
2004 financial results. -34-




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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:  October 29, 2004
    By:
    /s/ ANDREW F. JACOBSAndrew F. JacobsPresident and Chief Executive Officer Date:  October 29, 2004
    By:
    /s/ PHILLIP A. REINSCHPhillip A. ReinschSenior Vice President and
Chief Financial Officer -35-