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UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 FORM 10-Q  þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES
EXCHANGE ACT OF 1934For the quarterly period ended: March 31, 2004ORo
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES
EXCHANGE ACT OF 1934For the transition period from _______________ to ______________ Commission File Number: 1-8996 CAPSTEAD MORTGAGE CORPORATION  Maryland
(State or other jurisdiction of
incorporation or organization)
    
    75-2027937
(I.R.S. Employer
Identification No.)
 8401 North Central Expressway, Suite 800, Dallas, TX
(Address of principal executive offices)
    
    75225
(Zip Code)
 Registrants telephone number, including area code: (214) 874-2323 Indicate by check mark whether the Registrant (1) has filed all documents and
reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. YES
þ     NO o Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). YES
þ     NO o APPLICABLE ONLY TO CORPORATE ISSUERS: Indicate the number of shares outstanding of each of the issuers classes of
common stock, as of the last practicable date. Common Stock ($0.01 par value)
    
    14,854,952 as of April 30, 2004




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CAPSTEAD MORTGAGE CORPORATION
FORM 10-Q
FOR THE QUARTER ENDED MARCH 31, 2004  
 INDEX PagePART I.  FINANCIAL INFORMATIONITEM 1. Financial StatementsConsolidated Balance Sheets  March 31, 2004 and December 31, 2003
    
    
    3Consolidated Statements of Operations  Quarter Ended March 31, 2004 and 2003
    
    
    4Consolidated Statements of Cash Flows  Quarter Ended March 31, 2004 and 2003
    
    
    5Notes to Consolidated Financial Statements
    
    
    6ITEM 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    15ITEM 3. Qualitative and Quantitative Disclosure of Market Risk
    
    
    31ITEM 4. Controls and Procedures
    
    
    31PART II.  OTHER INFORMATIONITEM 4. Submission of Matters to a Vote of Security Holders
    
    
    31ITEM 6. Exhibits and Reports on Form 8-K
    
    
    32SIGNATURES
    
    
    32Computation of Ratio Of EarningsCertification Pursuant to Section 302Certification Pursuant to Section 302Certification Pursuant to Section 906
  -2-




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PART I.  FINANCIAL INFORMATION 
 ITEM 1. FINANCIAL STATEMENTS 
 CAPSTEAD MORTGAGE CORPORATION
CONSOLIDATED BALANCE SHEETS
(In thousands, except per share amounts) March 31, 2004
    
    December 31, 2003(unaudited)
    
    (NOTE 2)AssetsMortgage securities and similar investments
($2.2 billion pledged under repurchase arrangements in 2004)
    
    $
    2,415,164
    
    
    $
    2,195,117CMO collateral and investments
    
    
    129,302
    
    
    
    167,5712,544,466
    
    
    
    2,362,688Real estate held for lease, net of accumulated depreciation
    
    
    132,487
    
    
    
    133,414Receivables and other assets
    
    
    41,814
    
    
    
    41,880Cash and cash equivalents
    
    
    2,896
    
    
    
    16,340$
    2,721,663
    
    
    $
    2,554,322LiabilitiesRepurchase arrangements and similar borrowings
    
    $
    2,168,419
    
    
    $
    1,975,178Collateralized mortgage obligations (CMOs)
    
    
    128,629
    
    
    
    166,807Borrowings secured by real estate
    
    
    120,154
    
    
    
    120,206Common stock dividend payable
    
    
    7,807
    
    
    
    8,829Accounts payable and accrued expenses
    
    
    3,736
    
    
    
    6,2642,428,745
    
    
    
    2,277,284Stockholders equityPreferred stock  $0.10 par value; 100,000 shares authorized:$1.60 Cumulative Preferred Stock, Series A,
209 and 211 shares issued and outstanding at
March 31, 2004 and December 31, 2003, respectively
($3,435 aggregate liquidation preference)
    
    
    2,928
    
    
    
    2,956$1.26 Cumulative Convertible Preferred Stock, Series B,
15,819 shares issued and outstanding at
March 31, 2004 and December 31, 2003
($180,025 aggregate liquidation preference)
    
    
    176,707
    
    
    
    176,707Common stock  $0.01 par value; 100,000 shares authorized;14,837 and 14,015 shares issued and outstanding at
March 31, 2004 and December 31, 2003, respectively
    
    
    148
    
    
    
    140Paid-in capital
    
    
    469,605
    
    
    
    456,198Accumulated deficit
    
    
    (387,718
    )
    
    
    (387,718
    )Accumulated other comprehensive income
    
    
    31,248
    
    
    
    28,755292,918
    
    
    
    277,038$
    2,721,663
    
    
    $
    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 March 312004
    
    2003Interest income:Mortgage securities and similar investments
    
    $
    19,437
    
    
    $
    25,137CMO collateral and investments
    
    
    2,506
    
    
    
    14,968Total interest income
    
    
    21,943
    
    
    
    40,105Interest and related expense:Repurchase arrangements and similar borrowings
    
    
    5,830
    
    
    
    7,219CMO borrowings
    
    
    2,293
    
    
    
    15,339Mortgage insurance and other
    
    
    47
    
    
    
    109Total interest and related expense
    
    
    8,170
    
    
    
    22,667Net margin on financial assets
    
    
    13,773
    
    
    
    17,438Real estate lease income
    
    
    2,525
    
    
    
    2,521Real estate-related expense:Interest
    
    
    1,085
    
    
    
    1,092Depreciation
    
    
    927
    
    
    
    927Total real estate-related expense
    
    
    2,012
    
    
    
    2,019Net margin on real estate held for lease
    
    
    513
    
    
    
    502Other revenue (expense):Gain on asset sales and CMO redemptions
    
    
    
    
    
    
    1,748CMO administration and other
    
    
    67
    
    
    
    220Incentive fee payable to former affiliate
    
    
    
    
    
    
    (303
    )Other operating expense
    
    
    (1,999
    )
    
    
    (2,062
    )Total other revenue (expense)
    
    
    (1,932
    )
    
    
    (397
    )Net income
    
    $
    12,354
    
    
    $
    17,543Net income
    
    $
    12,354
    
    
    $
    17,543Less cash dividends on preferred shares
    
    
    (5,067
    )
    
    
    (5,070
    )Net income available to common stockholders
    
    $
    7,287
    
    
    $
    12,473Net income per common share:Basic
    
    $
    0.51
    
    
    $
    0.90Diluted
    
    
    0.50
    
    
    
    0.75Cash dividends declared per share:Common
    
    $
    0.530
    
    
    $
    0.940Series A Preferred
    
    
    0.400
    
    
    
    0.400Series B Preferred
    
    
    0.315
    
    
    
    0.315
 See accompanying notes to consolidated financial statements. -4-




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CAPSTEAD MORTGAGE CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited) Quarter Ended March 312004
    
    2003Operating activities:Net income
    
    $
    12,354
    
    
    $
    17,543Noncash items:Amortization of discount and premium
    
    
    2,009
    
    
    
    5,999Depreciation and other amortization
    
    
    1,117
    
    
    
    1,254Recognition of rent abatement
    
    
    43
    
    
    
    (27
    )Gain on asset sales and CMO redemptions
    
    
    
    
    
    
    (1,748
    )Change in incentive fee payable to former affiliate
    
    
    
    
    
    
    (5,080
    )Net change in receivables, other assets,
accounts payable and accrued expenses
    
    
    (1,700
    )
    
    
    251Net cash provided by operating activities
    
    
    13,823
    
    
    
    18,192Investing activities:Purchases of mortgage securities and similar investments
    
    
    (368,700
    )
    
    
    (28,540
    )Principal collections on mortgage securities
and similar investments
    
    
    148,054
    
    
    
    216,479Proceeds from asset sales
    
    
    
    
    
    
    34,329CMO collateral:Principal collections
    
    
    37,757
    
    
    
    260,328Decrease in accrued interest receivable
    
    
    233
    
    
    
    1,732Net cash provided by (used in) investing activities
    
    
    (182,656
    )
    
    
    484,328Financing activities:Net increase (decrease) in repurchase arrangements
and similar borrowings
    
    
    193,241
    
    
    
    (66,530
    )Principal payments on borrowings secured by real estate
    
    
    (52
    )
    
    
    (52
    )CMO borrowings:Principal payments on securities
    
    
    (37,563
    )
    
    
    (297,039
    )Decrease in accrued interest payable
    
    
    (218
    )
    
    
    (1,564
    )Capital stock transactions
    
    
    13,877
    
    
    
    (2
    )Dividends paid
    
    
    (13,896
    )
    
    
    (121,655
    )Net cash provided by (used in) financing activities
    
    
    155,389
    
    
    
    (486,842
    )Net change in cash and cash equivalents
    
    
    (13,444
    )
    
    
    15,678Cash and cash equivalents at beginning of period
    
    
    16,340
    
    
    
    59,003Cash and cash equivalents at end of period
    
    $
    2,896
    
    
    $
    74,681
 See accompanying notes to consolidated financial statements. -5-




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CAPSTEAD MORTGAGE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 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 by government-sponsored entities, either
Fannie Mae, Freddie Mac or Ginnie Mae (Agency Securities). Capstead has also
made limited investments in credit-sensitive commercial real estate-related
assets, including the direct ownership of real estate. Management believes
that such investments, when available at favorable prices and combined with the
prudent use of leverage, can produce attractive risk-adjusted returns over the
long term with relatively low sensitivity to changes in interest rates. The earning capacity of Capsteads financial asset portfolios is influenced by
the overall size and composition of the portfolios, the relationship between
short- and long-term interest rates (the yield curve) and the extent the
Company continues to invest its liquidity in these portfolios. Although the
Company has had success in recent quarters acquiring ARM securities at
relatively attractive prices and runoff caused by mortgage prepayments has
moderated considerably during the first quarter of 2004, runoff remains a
challenge to earnings generated by these portfolios. To the extent the
proceeds of mortgage prepayments and other maturities are not reinvested or
cannot be reinvested at a rate of return on invested capital at least equal to
the return earned on previous investments, earnings and common dividends may
decline. NOTE 2  BASIS OF PRESENTATION Interim Financial Reporting The accompanying unaudited consolidated financial statements have been prepared
in accordance with accounting principles generally accepted in the United
States (GAAP) for interim financial information and with the instructions to
Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include
all of the information and footnotes required by GAAP for complete financial
statements. In the opinion of management, all adjustments (consisting of
normal recurring accruals) considered necessary for a fair presentation have
been included. Operating results for the quarter ended March 31, 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 $15,000 for
the three months ended March 31, 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 March 312004
    
    2003Numerator for basic net income per common share:Net income
    
    $
    12,354
    
    
    $
    17,543Less all preferred share dividends
    
    
    (5,067
    )
    
    
    (5,070
    )Net income available to common stockholders
    
    $
    7,287
    
    
    $
    12,473Weighted average common shares outstanding
    
    
    14,267
    
    
    
    13,935Basic net income per common share
    
    $
    0.51
    
    
    $
    0.90Numerator for diluted net income per common share:Net income
    
    $
    12,354
    
    
    $
    17,543Less dividends on Series B preferred shares
    
    
    (4,983
    )
    
    
    $
    7,371
    
    
    $
    17,543Denominator for diluted net income per common share:Weighted average common shares outstanding
    
    
    14,267
    
    
    
    13,935Net effect of dilutive stock options
    
    
    39
    
    
    
    90Net effect of dilutive preferred shares:Series A
    
    
    314
    
    
    
    317Series B
    
    
    
    
    
    
    8,91014,620
    
    
    
    23,252Diluted net income per common share
    
    $
    0.50
    
    
    $
    0.75
 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 March 31, 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 March 31, 2004
are mezzanine classes and therefore carry credit risk associated with the
underlying pools of commercial mortgage loans that is mitigated by subordinate
bonds held by other investors. The maturity of mortgage securities is directly
affected by the rate of principal prepayments on the underlying loans. -7-




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Fixed-rate investments have fixed rates of interest and initial expected
weighted average lives of greater than five years. Adjustable-rate investments
have interest rates that adjust at least annually to more current interest
rates. For instance, mortgage loans underlying ARM securities either (i)
adjust annually based on a specified margin over the one-year Constant Maturity
U.S. Treasury Note Rate (One-year CMT), (ii) adjust semiannually based on a
specified margin over the six-month London Interbank Offered Rate (LIBOR), or
(iii) adjust monthly based on a specific margin over an index such as LIBOR or
the Cost of Funds Index as published by the Eleventh District Federal Reserve
Bank (COFI), subject to periodic and lifetime limits on the amount of such
adjustments during any single interest rate adjustment period and over the life
of the loan. CMBS held as of March 31, 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): AveragePrincipal
    
    Premiums
    
    
    
    
    
    Carrying
    
    Coupon
    
    AverageBalance
    
    (Discounts)
    
    Basis
    
    Amount (a)
    
    Rate (b)
    
    Yield (b)March 31, 2004Agency Securities:Fannie Mae/Freddie Mac:Fixed-rate
    
    $
    54,932
    
    
    $
    151
    
    
    $
    55,083
    
    
    $
    55,157
    
    
    
    6.65
    %
    
    
    9.79
    %LIBOR/CMT ARMs
    
    
    1,192,839
    
    
    
    20,054
    
    
    
    1,212,893
    
    
    
    1,231,416
    
    
    
    3.57
    
    
    
    3.16COFI ARMs
    
    
    84,744
    
    
    
    (2,451
    )
    
    
    82,293
    
    
    
    85,742
    
    
    
    3.48
    
    
    
    4.36Ginnie Mae ARMs
    
    
    830,939
    
    
    
    8,775
    
    
    
    839,714
    
    
    
    847,428
    
    
    
    4.17
    
    
    
    3.432,163,454
    
    
    
    26,529
    
    
    
    2,189,983
    
    
    
    2,219,743
    
    
    
    3.88
    
    
    
    3.33Non-agency Securities:Fixed-rate
    
    
    48,638
    
    
    
    69
    
    
    
    48,707
    
    
    
    48,791
    
    
    
    6.77
    
    
    
    6.15LIBOR/CMT ARMs
    
    
    71,464
    
    
    
    1,057
    
    
    
    72,521
    
    
    
    73,411
    
    
    
    4.01
    
    
    
    3.07120,102
    
    
    
    1,126
    
    
    
    121,228
    
    
    
    122,202
    
    
    
    5.13
    
    
    
    4.88CMBS (c)
    
    
    73,219
    
    
    
    (3
    )
    
    
    73,216
    
    
    
    73,219
    
    
    
    2.14
    
    
    
    2.19$
    2,356,775
    
    
    $
    27,652
    
    
    $
    2,384,427
    
    
    $
    2,415,164
    
    
    
    3.89
    
    
    
    3.42December 31, 2003Agency Securities:Fannie Mae/Freddie Mac:Fixed-rate
    
    $
    2,072
    
    
    $
    12
    
    
    $
    2,084
    
    
    $
    2,160
    
    
    
    10.00
    %
    
    
    9.38
    %LIBOR/CMT ARMs
    
    
    1,050,761
    
    
    
    15,626
    
    
    
    1,066,387
    
    
    
    1,084,492
    
    
    
    3.67
    
    
    
    3.60COFI ARMs
    
    
    90,669
    
    
    
    (2,623
    )
    
    
    88,046
    
    
    
    91,566
    
    
    
    3.57
    
    
    
    4.84Ginnie Mae ARMs
    
    
    726,876
    
    
    
    7,830
    
    
    
    734,706
    
    
    
    739,987
    
    
    
    4.27
    
    
    
    4.101,870,378
    
    
    
    20,845
    
    
    
    1,891,223
    
    
    
    1,918,205
    
    
    
    3.90
    
    
    
    3.88Non-agency Securities:Fixed-rate
    
    
    118,638
    
    
    
    174
    
    
    
    118,812
    
    
    
    118,812
    
    
    
    6.66
    
    
    
    6.25LIBOR/CMT ARMs
    
    
    81,425
    
    
    
    1,293
    
    
    
    82,718
    
    
    
    83,724
    
    
    
    4.42
    
    
    
    3.64200,063
    
    
    
    1,467
    
    
    
    201,530
    
    
    
    202,536
    
    
    
    5.75
    
    
    
    4.63CMBS (c)
    
    
    74,376
    
    
    
    (9
    )
    
    
    74,367
    
    
    
    74,376
    
    
    
    2.21
    
    
    
    2.83Commercial loans
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    8.40$
    2,144,817
    
    
    $
    22,303
    
    
    $
    2,167,120
    
    
    $
    2,195,117
    
    
    
    4.02
    
    
    
    3.97
  (a)
    
    Includes unrealized gains and losses for securities classified as
available-for-sale, if applicable (see NOTE 10).(b)
    
    Average Coupon Rate is presented net of servicing and other fees as of
the indicated balance sheet date. Average Effective Rate is presented
for the quarter then ended, calculated including the amortization of
premiums and discounts, mortgage insurance costs on Non-agency Securities
and excluding unrealized gains and losses.(c)
    
    As of the indicated dates, these portfolios consisted nearly exclusively
of adjustable-rate investments. -8-




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NOTE 5 CMO COLLATERAL AND INVESTMENTS CMO collateral consists of Non-Agency Securities and related accrued interest,
all pledged to secure CMO borrowings (Pledged CMO Collateral). All principal
and interest on pledged mortgage securities is remitted directly to collection
accounts maintained by a trustee 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): March 31, 2004
    
    December 31, 2003Pledged CMO Collateral:Pledged mortgage securities
    
    $
    127,066
    
    
    $
    164,891Accrued interest receivable
    
    
    851
    
    
    
    1,085127,917
    
    
    
    165,976Unamortized premium
    
    
    1,385
    
    
    
    1,595$
    129,302
    
    
    $
    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 6.69% during the quarter ended March 31, 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 (see NOTE 12). The lease arrangement consists of a master lease covering all of the Properties
and individual property-level leases (referred to collectively as the Lease).
The Lease has an initial term of 20 years and provides for two 10-year renewal
periods. Beginning May 1, 2007, Brookdale will have the option of purchasing
all of the Properties from Capstead at the greater of fair value or Capsteads
original cost, after certain adjustments. After an initial three-month rent
concession period, Brookdale is responsible for paying all expenses associated
with the operation of the Properties, including real estate taxes, other
governmental charges, insurance, utilities and maintenance, and an amount
representing an attractive cash return on Capsteads equity in the Properties
after payment of monthly debt service subject to annual increases based upon
increases (capped at 3%) in the 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
December 31, 2003 are $3.1 million in unamortized rent abatements and $1.2
million of other rent receivables due from Brookdale. -9-




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##### Table of Contents



The following table summarizes carrying amounts of the Properties (in
thousands): March 31, 2004
    
    December 31, 2003Land
    
    $
    16,450
    
    
    $
    16,450Buildings
    
    
    119,550
    
    
    
    119,550Equipment and fixtures
    
    
    3,600
    
    
    
    3,600139,600
    
    
    
    139,600Accumulated depreciation
    
    
    (7,113
    )
    
    
    (6,186
    )$
    132,487
    
    
    $
    133,414
 NOTE 7  REPURCHASE ARRANGEMENTS AND SIMILAR BORROWINGS Capstead borrows under uncommitted repurchase arrangements with only
well-established investment banking firms. Repurchase arrangements pursuant to
which the Company pledges Agency and Non-agency Securities as collateral
generally have maturities of less than 31 days.* Repurchase arrangements with
CMBS pledged as collateral generally have longer initial maturities and may
feature renewal options. The terms and conditions of repurchase arrangements
and similar borrowings are negotiated on a transaction-by-transaction basis.
Repurchase arrangements and similar borrowings and related weighted average
interest rates, classified by type of collateral and maturities, were as
follows for the dates indicated (dollars in thousands): March 31, 2004
    
    December 31, 2003Borrowings
    
    Average
    
    Borrowings
    
    AverageOutstanding
    
    Rate
    
    Outstanding
    
    RateRepurchase arrangements:Agency Securities (less than 31 days)
    
    $
    2,003,717
    
    
    
    1.06
    %
    
    $
    1,735,027
    
    
    
    1.09
    %Non-agency Securities (less than 31 days)
    
    
    95,834
    
    
    
    1.43
    
    
    
    170,205
    
    
    
    1.57CMBS (less than 31 days)
    
    
    20,300
    
    
    
    1.29
    
    
    
    20,300
    
    
    
    1.36CMBS (greater than 90 days)
    
    
    48,568
    
    
    
    1.26
    
    
    
    49,646
    
    
    
    1.34$
    2,168,419
    
    
    
    1.09
    
    
    $
    1,975,178
    
    
    
    1.14
  *
    
    Subsequent to quarter-end, the Company entered into several longer
maturity repurchase arrangements totaling $200 million with maturities
ranging from one and one-half to two years. 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): March 31, 2004
    
    December 31, 2003CMOs
    
    $
    126,632
    
    
    $
    164,388Accrued interest payable
    
    
    720
    
    
    
    938Total obligation
    
    
    127,352
    
    
    
    165,326Unamortized premium
    
    
    1,277
    
    
    
    1,481$
    128,629
    
    
    $
    166,807Range of average interest rates
    
    1.45% to 9.45%
    
    1.50% to 9.42%Range of stated maturities
    
    
    2025 to 2030
    
    
    
    2025 to 2030Number of series
    
    
    6
    
    
    
    6
 -10-




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##### Table of Contents



Typically, principal payments on each series are made to each class in the
order of their stated maturities so that no payment of principal is made on any
class of bonds until all classes having an earlier stated maturity have been
paid in full. The maturity of each CMO series is directly affected by the rate
of principal prepayments on the related Pledged CMO Collateral. Each series is
also subject to redemption provided that certain requirements specified in the
related indenture have been met (referred to as Clean-up Calls); therefore,
the actual maturity of any series is likely to occur earlier than its stated
maturity. The weighted average effective interest rate for all CMOs was 6.12%
during the quarter ended March 31, 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): March 31, 2004
    
    December 31, 2003Borrowings
    
    Average
    
    Borrowings
    
    AverageOutstanding
    
    Rate
    
    Outstanding
    
    RateMortgage borrowings
    
    $
    19,313
    
    
    
    7.92
    %
    
    $
    19,365
    
    
    
    7.92
    %Tax-exempt bonds
    
    
    100,841
    
    
    
    2.55
    
    
    
    100,841
    
    
    
    2.54$
    120,154
    
    
    
    3.41
    
    
    $
    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 $190,000 at March 31, 2004 and included in
Receivables and other assets.Monthly principal and interest rate cap reserve
fund payments are made to the trustee for the eventual retirement of the bonds
by 2032 and the purchase of new cap agreements in 2007. In connection with the issuance of new tax-exempt bonds in November 2002,
Capstead placed into escrow with the trustee reserves for repairs and
replacements totaling $2.9 million. During 2003, the trustee released $1.5
million of these funds. Another $6.1 million is held by the trustee in
connection with Capstead posting a $6.0 million letter of credit from a rated
financial institution to collateralize certain of the bonds. These funds,
along with $1.7 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 $3.1 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 March 31, 2004. NOTE 10  DISCLOSURES REGARDING FAIR VALUES OF DEBT SECURITIES Estimated fair values of debt securities were determined using available market
information and appropriate valuation methodologies; however, considerable
judgment is required in interpreting market data to develop these estimates.
In addition, fair values fluctuate on a daily basis. Accordingly, estimates
presented herein are not necessarily indicative of the amounts that could be
realized in a current market exchange. The use of different market assumptions
and/or estimation methodologies may have a material effect on estimated fair
values. The fair value of Agency Securities, Non-agency Securities and CMBS -11-




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##### Table of Contents



were estimated using either (i) quoted market prices when available, including
quotes made by lenders in connection with designating collateral for repurchase
arrangements, or (ii) offer prices for similar assets or market positions. The
fair value of Pledged CMO Collateral was based on projected cash flows, after
payment on the related CMOs, determined using market discount rates and
prepayment assumptions. The maturity of mortgage assets is directly affected by
the rate of principal payments on the underlying mortgage loans and, for
Pledged CMO Collateral, Clean-up Calls of the remaining CMOs outstanding.
Investments not held in the form of debt or equity securities are excluded from
these disclosures. The following tables summarize fair value disclosures for available-for-sale
debt securities (in thousands): Gross
    
    GrossCost
    
    Unrealized
    
    Unrealized
    
    FairBasis
    
    Gains
    
    Losses
    
    ValueAs of March 31, 2004Agency Securities:Fixed-rate
    
    $
    800
    
    
    $
    74
    
    
    $
    
    
    
    $
    874ARMs
    
    
    2,134,900
    
    
    
    30,021
    
    
    
    335
    
    
    
    2,164,5862,135,700
    
    
    
    30,095
    
    
    
    335
    
    
    
    2,165,460Non-agency Securities:Fixed-rate
    
    
    1,068
    
    
    
    84
    
    
    
    
    
    
    
    1,152ARMs
    
    
    52,488
    
    
    
    894
    
    
    
    4
    
    
    
    53,37853,556
    
    
    
    978
    
    
    
    4
    
    
    
    54,530CMBS
    
    
    73,216
    
    
    
    16
    
    
    
    13
    
    
    
    73,219CMO collateral and investments
    
    
    14,752
    
    
    
    431
    
    
    
    
    
    
    
    15,183$
    2,277,224
    
    
    $
    31,520
    
    
    $
    352
    
    
    $
    2,308,392As of December 31, 2003Agency Securities:Fixed-rate
    
    $
    827
    
    
    $
    76
    
    
    $
    
    
    
    $
    903ARMs
    
    
    1,889,139
    
    
    
    27,159
    
    
    
    253
    
    
    
    1,916,0451,889,966
    
    
    
    27,235
    
    
    
    253
    
    
    
    1,916,948Non-agency Securities
    
    
    58,613
    
    
    
    1,009
    
    
    
    3
    
    
    
    59,619CMBS
    
    
    74,367
    
    
    
    24
    
    
    
    15
    
    
    
    74,376CMO collateral and investments
    
    
    16,440
    
    
    
    499
    
    
    
    
    
    
    
    16,939$
    2,039,386
    
    
    $
    28,767
    
    
    $
    271
    
    
    $
    2,067,882
 Held-to-maturity debt securities consist of Pledged CMO Collateral and
collateral released from the related CMO indentures pursuant to Clean-up Calls
and held as Agency Securities and Non-agency Securities. Fair value
disclosures for debt securities held-to-maturity were as follows (in
thousands): Gross
    
    GrossCost
    
    Unrealized
    
    Unrealized
    
    FairBasis
    
    Gains
    
    Losses
    
    ValueAs of March 31, 2004Released CMO Collateral:Agency Securities  Fixed-rate
    
    $
    54,283
    
    
    $
    2,944
    
    
    $
    
    
    
    $
    57,227Non-agency Securities:Fixed-rate
    
    
    47,639
    
    
    
    1,937
    
    
    
    
    
    
    
    49,576ARMs
    
    
    20,033
    
    
    
    109
    
    
    
    268
    
    
    
    19,874121,955
    
    
    
    4,990
    
    
    
    268
    
    
    
    126,677Pledged CMO Collateral
    
    
    114,119
    
    
    
    190
    
    
    
    
    
    
    
    114,309$
    236,074
    
    
    $
    5,180
    
    
    $
    268
    
    
    $
    240,986
 -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
Securities
Fixed-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 March 312004
    
    2003Sale of debt securities held available-for-sale:Amortized cost
    
    $
    
    
    
    $
    28,540Gain
    
    
    
    
    
    
    1,044Sale of released CMO collateral held-to-maturity:Amortized cost
    
    
    
    
    
    
    4,006Gain
    
    
    
    
    
    
    98
 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 March 312004
    
    2003Net income
    
    $
    12,354
    
    
    $
    17,543Other comprehensive income (loss):Unrealized gain on Derivatives held as cash flow hedges:Change in unrealized gain during period
    
    
    (128
    )
    
    
    (45
    )Reclassification adjustment for amounts included in net income
    
    
    (51
    )
    
    
    (27
    )(179
    )
    
    
    (72
    )Unrealized gain on debt securities:Change in unrealized gain during period
    
    
    2,672
    
    
    
    (161
    )Reclassification adjustment for gain included in net income
    
    
    
    
    
    
    (1,044
    )Other comprehensive income (loss)
    
    
    2,493
    
    
    
    (1,277
    )Comprehensive income
    
    $
    14,847
    
    
    $
    16,266
 -13-




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##### Table of Contents



NOTE 12  TRANSACTIONS WITH FORMER AFFILIATES Pursuant to a management contract entered into in April 2000, Fortress provided
the services of its chairman to serve as Capsteads chairman and chief
executive and of other individuals as necessary to perform support services for
him. On July 22, 2003, Fortress chairman resigned from his positions with
Capstead and the management contract with Fortress was terminated. Under the
terms of the contract, Fortress was entitled to a $375,000 base annual fee and
participated with management and employees in an incentive fee program based on
the Companys expected performance against predetermined benchmarks established
by members of the Board of Directors independent of Fortress. Included in
Other operating expenseis $93,750 of base fees paid to Fortress for services
rendered during the three months ended March 31, 2003. See NOTE 6 for
information regarding Fortress involvement through its affiliate Brookdale in
the acquisition and long-term leasing of senior living facilities acquired by
Capstead in May 2002. NOTE 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 March 312004
    
    2003Average
    
    
    
    
    
    AverageAmount
    
    Rate
    
    Amount
    
    RateInterest income:Mortgage securities and similar investments
    
    $
    19,437
    
    
    
    3.42
    %
    
    $
    25,137
    
    
    
    4.35
    %CMO collateral and investments
    
    
    2,506
    
    
    
    6.69
    
    
    
    14,968
    
    
    
    6.46Total interest income
    
    
    21,943
    
    
    
    
    
    
    
    40,105Interest expense:Repurchase arrangements and
similar borrowings
    
    
    5,830
    
    
    
    1.11
    %
    
    
    7,219
    
    
    
    1.34CMOs
    
    
    2,293
    
    
    
    6.12
    
    
    
    15,339
    
    
    
    6.63Total interest expense
    
    
    8,123
    
    
    
    
    
    
    
    22,558$
    13,820
    
    
    
    
    
    
    $
    17,547
 Changes in interest income and interest expense due to changes in interest
rates versus changes in volume were as follows (in thousands): Quarter Ended March 31, 2004Rate*
    
    Volume*
    
    TotalInterest income:Mortgage securities and similar investments
    
    $
    (5,342
    )
    
    $
    (358
    )
    
    $
    (5,700
    )CMO collateral and investments
    
    
    515
    
    
    
    (12,977
    )
    
    
    (12,462
    )Total interest income
    
    
    (4,827
    )
    
    
    (13,335
    )
    
    
    (18,162
    )Interest expense:Repurchase arrangements and similar
borrowings
    
    
    (1,237
    )
    
    
    (152
    )
    
    
    (1,389
    )CMOs
    
    
    (1,096
    )
    
    
    (11,950
    )
    
    
    (13,046
    )Total interest expense
    
    
    (2,333
    )
    
    
    (12,102
    )
    
    
    (14,435
    )$
    (2,494
    )
    
    $
    (1,233
    )
    
    $
    (3,727
    )
  *
    
    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. -14-




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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 by
government-sponsored entities, either Fannie Mae, Freddie Mac or Ginnie Mae
(Agency Securities). The Company has also made limited investments in
credit-sensitive commercial 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 levels of mortgage prepayments and
the availability of attractively priced investments. After several years of
steadily declining mortgage securities portfolio balances, primarily because of
high levels of mortgage prepayments and a lack of compelling investment
opportunities, during the latter half of 2003 market conditions allowed for the
acquisition of sufficient ARM securities at relatively attractive prices to
more than offset portfolio runoff. This opportunity became available when
long-term interest rates moved sharply higher in response to indications that
the economy was recovering from a sustained period of economic weakness. Although this optimism proved premature and interest rates declined during the
first quarter in response to weak job growth and other indications of economic
weakness, the Company has been successful this quarter in acquiring sufficient
ARM securities, again at relatively attractive prices, to more than offset
portfolio runoff. These acquisitions have allowed for the sequential growth of
the mortgage securities portfolio for the past three quarters and this trend is
expected to continue at least through the second quarter of 2004. The Company
intends to continue pursuing the acquisition of attractively priced ARM
securities, while also investigating other real estate-related opportunities. Subsequent to quarter-end, recent strong economic indicators have many
believing the Federal Reserve could be forced to begin raising short-term
interest rates later this year and long-term interest rates have moved higher
in response. Although higher interest rates may create opportunities to acquire
additional investments at attractive prices, higher short-term interest rates
will increase the Companys borrowing costs, thereby reducing financing spreads
(the difference between the yields earned on these investments and the rates
charged on related borrowings). Although rising borrowing costs can eventually
be mitigated by ARM security yield increases, interest rates on the Companys
borrowings rise (and fall) almost immediately while ARM security yields change
slowly by comparison because the underlying loans reset only once or twice a
year and the amount of each reset can be limited or capped. Consequently,
while the wide financing spreads Capstead has enjoyed in recent years have been
the driving force behind the Companys earnings and dividends, if short-term
interest rates rise quickly, spreads will narrow and margins earned on its ARM
securities will decline. -15-




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##### Table of Contents



Risk Factors Under the captions Effects of Interest Changes, Risks Associated with
Credit-Sensitive Investments, Risks Associated with Owning Real Estate and
Investment Company Act of 1940 are discussions of risk factors 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
these factors while reading this document. Mortgage Securities and Similar Investments As of March 31, 2004, the mortgage securities and similar investments portfolio
consisted primarily of ARM Agency Securities. Agency Securities are AAA-rated
and are considered to have limited credit risk. Non-agency securities are
private mortgage pass-through securities whereby the related credit risk of the
underlying loans is borne by AAA-rated private mortgage insurers or by the
Company (Non-agency Securities). Commercial mortgage-backed securitizations
generally have senior, mezzanine and subordinate classes of bonds with the
lower classes providing credit enhancement to the more senior classes.
Commercial mortgage-backed securities (CMBS) held by the Company at March 31,
2004 are mezzanine classes and therefore carry credit risk associated with the
underlying pools of commercial mortgage loans that is mitigated by subordinate
bonds held by other investors. Mortgage securities held by Capstead are financed under repurchase arrangements
with investment banking firms pursuant to which specific securities are pledged
as collateral. Should the Company acquire financial assets that are not
mortgage-backed securities, similar financing arrangements with other parties,
such as commercial banks, may be employed (see Liquidity and Capital
Resources). The Companys mortgage securities and similar investments portfolio rose during
the first quarter of 2004 to $2.4 billion from $2.2 billion at December 31,
2003, representing the third straight quarter of portfolio growth after several
years of declines. Acquisitions during the first quarter totaled $360 million,
consisting almost exclusively of ARM Agency Securities. Runoff during the first
quarter totaled $148 million, significantly less than the $225 million
experienced during the fourth quarter of 2003, primarily reflecting lower
levels of mortgage prepayments. Although mortgage prepayments moderated
considerably during the first quarter of 2004, runoff caused by mortgage
prepayments remains a challenge to earnings generated by the Companys mortgage
securities. The Company anticipates that runoff will be higher in the second
quarter than in the first quarter due to lower prevailing mortgage rates in
February and March before again declining to more moderate levels. The Company
also securitized with Fannie Mae $53 million of its high coupon fixed-rate
Non-Agency Securities in order to improve these securities financing spreads
and liquidity. Although the Company has had continued success subsequent to quarter-end
acquiring additional ARM securities such that it expects further portfolio
growth during the second quarter of 2004, there can be no assurance that
attractively priced ARM securities will continue to be available. To the
extent the proceeds of mortgage prepayments and other maturities are not
reinvested or cannot be reinvested at a rate of return on invested capital at
least equal to the return earned on previous investments, earnings and common
dividends may decline. The future size and composition of the Companys
investment portfolios will depend on market conditions, including levels of
mortgage prepayments and the availability of attractively priced investments. The following yield and cost analysis illustrates results achieved during the
first quarter of 2004 for components of the mortgage securities and similar
investments portfolio and anticipated second quarter -16-




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##### Table of Contents



2004 asset yields and borrowing rates based on interest rates in effect on
April 22, 2004 (the date first quarter 2004 results were released) (dollars in
thousands): 1st Quarter Average(a)
    
    As of March 31, 2004Projected
    
    LifetimeActual
    
    Actual
    
    Premiums
    
    
    
    
    
    2nd Quarter
    
    PrepaymentBasis
    
    Yield/Cost
    
    Runoff
    
    (Discounts)
    
    Basis(a)
    
    Yield/Cost(b)
    
    AssumptionsAgency Securities:Fannie Mae/Freddie
Mac:Fixed-rate
    
    
    2,051
    
    
    
    9.79
    %
    
    
    14
    %
    
    $
    151
    
    
    $
    55,083
    
    
    
    6.23
    %
    
    
    30
    %ARMs:LIBOR/CMT
    
    
    1,127,291
    
    
    
    3.16
    
    
    
    20
    
    
    
    20,054
    
    
    
    1,212,893
    
    
    
    2.90
    
    
    
    25COFI
    
    
    85,678
    
    
    
    4.36
    
    
    
    24
    
    
    
    (2,451
    )
    
    
    82,293
    
    
    
    4.44
    
    
    
    25Ginnie Mae ARMs
    
    
    791,686
    
    
    
    3.43
    
    
    
    24
    
    
    
    8,775
    
    
    
    839,714
    
    
    
    3.22
    
    
    
    262,006,706
    
    
    
    3.33
    
    
    
    22
    
    
    
    26,529
    
    
    
    2,189,983
    
    
    
    3.16
    
    
    
    26Non-agency Securities:Fixed-rate
    
    
    110,796
    
    
    
    6.15
    
    
    
    48
    
    
    
    69
    
    
    
    48,707
    
    
    
    6.38
    
    
    
    32ARMs
    
    
    77,427
    
    
    
    3.07
    
    
    
    40
    
    
    
    1,057
    
    
    
    72,521
    
    
    
    3.36
    
    
    
    40188,223
    
    
    
    4.88
    
    
    
    45
    
    
    
    1,126
    
    
    
    121,228
    
    
    
    4.57
    
    
    
    37CMBS
    
    
    73,377
    
    
    
    2.19
    
    
    
    6
    
    
    
    (3
    )
    
    
    73,216
    
    
    
    2.27
    
    
    
    2,268,306
    
    
    
    3.42
    
    
    
    24
    
    
    $
    27,652
    
    
    
    2,384,427
    
    
    
    3.20
    
    
    
    25Borrowings
    
    
    2,080,754
    
    
    
    1.11
    
    
    
    
    
    
    
    
    
    
    
    2,168,419
    
    
    
    1.10Capital employed/
financing spread
    
    $
    187,552
    
    
    
    2.31
    
    
    
    
    
    
    
    
    
    
    $
    216,008
    
    
    
    2.10Return on assets(c)
    
    
    
    
    
    
    2.39
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2.19
  (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 second quarter of 2004 reflect ARM
coupon resets and lifetime prepayment assumptions as adjusted for
expected prepayments for this quarter only, as of April 22, 2004. Actual
yields realized in future periods will largely depend upon (i) changes in
portfolio composition, (ii) ARM coupon resets, (iii) actual prepayments
and (iv) any changes in lifetime prepayment assumptions.(c)
    
    The Company generally uses its liquidity to pay down borrowings.
Return on assets is calculated on an annualized basis assuming the use of
this liquidity to reduce borrowing costs (see Utilization of Capital and
Potential Liquidity). Financing spreads declined 16 basis points during the first quarter of 2004 to
2.31%, substantially all attributable to lower portfolio yields. The overall
yield earned on the portfolio averaged 3.42% during the first quarter, compared
to an average yield of 3.60% earned during the previous quarter. Yields on ARM
securities fluctuate as coupon interest rates on the underlying mortgage loans
reset to reflect current interest rates and are expected to continue to decline
in the coming quarters. For example, if interest rates remain at rates in
effect April 22, 2004, the average yield on the portfolio could decline
approximately 37 basis points by the first quarter of 2005. Actual yields will
depend on portfolio composition as well as fluctuations in, and market
expectations for fluctuations in, interest rates and levels of mortgage
prepayments. Average rates on related borrowings declined 2 basis points to
1.11% during the first quarter of 2004 compared to the previous quarter. The
Companys borrowing rates depend 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. -17-




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##### Table of Contents



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 March 31,
2004, the Company holds Clean-up Call rights on only one of its six remaining
CMOs. Consequently, additional significant gains from CMO redemptions are not
expected to occur. CMO collateral and investments, net of related bonds, was $673,000 at March 31,
2004, compared to $764,000 at December 31, 2003. Without the issuance of CMOs
in which the Company retains residual interests, or the acquisition of other
CMO investments, this portfolio is not expected to contribute significantly to
operating results in future periods. Real Estate Held For Lease In May 2002 Capstead acquired six independent senior living properties
(wherein the operator of the facility provides most of the tenants little, if
any, medical care) (the Properties). Concurrent with the acquisition of the
Properties, the Company entered into a long-term net-lease arrangement (the
Lease) with Brookdale Living Communities, Inc., (Brookdale), under which
Brookdale is responsible for the ongoing operation and management of the
Properties. Brookdale, an owner, operator, developer and manager of senior
living facilities, is a majority-owned affiliate of Fortress Investment Group,
LLC, which, together with its affiliates is referred to as Fortress. Until
July 2003 Fortress was affiliated with Capstead (see NOTE 12 to the
accompanying financial statements). The Lease has an initial term of 20 years and provides for two 10-year renewal
periods. Beginning in May 2007, Brookdale will have the option of purchasing
all of the Properties from Capstead at the greater of fair value or Capsteads
original cost, after certain adjustments. Under the terms of the Lease,
Brookdale is responsible for paying all expenses associated with operating the
Properties, including real estate taxes, other government charges, insurance,
utilities and maintenance, and an amount representing an attractive cash return
on Capsteads equity in the Properties after payment of monthly debt service.
In keeping with Capsteads strategy of owning investments that can produce
attractive risk-adjusted returns over the long term with relatively low
sensitivity to changes in interest rates, any future changes in monthly debt
service requirements are the responsibility of Brookdale under the terms of the
Lease. The following table summarizes information about the Properties: YearProperty
    
    Location
    
    Units (a)
    
    Occupancy(b)
    
    OpenedChambrel at Roswell
    
    Roswell, GA
    
    
    280 (256 IL; 24 AL)
    
    
    
    95.4
    %
    
    
    1987Chambrel at Pinecastle
    
    Ocala, FL
    
    
    161 (120 IL; 41 AL)
    
    
    
    96.9
    
    
    
    1987Chambrel at Island Lake
    
    Longwood, FL
    
    
    269 (229 IL; 40 AL)
    
    
    
    97.8
    
    
    
    1985Chambrel at Montrose
    
    Akron, OH
    
    
    168 (136 IL; 32 AL)
    
    
    
    97.0
    
    
    
    1987Chambrel at Williamsburg
    
    Williamsburg, VA
    
    
    255 (200 IL; 55 AL)
    
    
    
    98.8
    
    
    
    1987Chambrel at Club Hill
    
    Garland, TX
    
    
    260 (192 IL; 68 AL)
    
    
    
    89.6
    
    
    
    1987Total
    
    
    
    
    1,393 (1,133 IL; 260 AL)
    
    
    
    95.8
  (a)
    
    IL refers to independent living units. AL refers to assisted living
units.(b)
    
    As of March 31, 2004. -18-




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##### Table of Contents



Results of Capital Raising Activity Between February 2 and March 30, 2004, the Company sold 791,900 common shares
into the open market on a limited basis and such sales may resume during the
second quarter. As of quarter-end, Capstead raised $13.4 million of new common
equity under this program at an average price of $16.94 per share, after
expenses. The proceeds from these issuances have been invested in
attractively-priced ARM securities. Book Value per Common Share As of March 31, 2004, the Companys book value per common share was $7.38, an
increase of $0.70 since year-end. This increase is largely attributable to the
issuance of new capital (approximately $0.55 per share), offset somewhat by
dividend payments in excess of quarterly net income (approximately $0.04 per
share). In addition, lower prevailing interest rates at quarter-end resulted
in an increase 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). This unrealized gain can be expected
to fluctuate with changes in portfolio size and composition as well as changes
in interest rates and market liquidity, and such changes will largely be
reflected in book value per common share. Book value will also be affected by
other factors, including capital stock transactions and the level of dividend
distributions relative to quarterly net income; however, temporary changes in
fair values of investments not carried at fair value on the Companys balance
sheet generally will not affect book value. Utilization of Capital and Potential Liquidity The following table illustrates Capsteads utilization of capital and potential
liquidity as of March 31, 2004 in comparison with December 31, 2003 (in
thousands): Capital
    
    PotentialAssets
    
    Borrowings
    
    Employed
    
    Liquidity(a)Mortgage securities and similar
investments:Agency Securities
    
    $
    2,219,743
    
    
    $
    2,003,717
    
    
    $
    216,026
    
    
    $
    154,995Non-agency Securities
    
    
    122,202
    
    
    
    95,834
    
    
    
    26,368
    
    
    
    19,054CMBS
    
    
    73,219
    
    
    
    68,868
    
    
    
    4,351
    
    
    
    3342,415,164
    
    
    
    2,168,419
    
    
    
    246,745
    
    
    
    174,383CMO collateral and investments
    
    
    129,302
    
    
    
    128,629
    
    
    
    673
    
    
    
    Real estate held for lease
    
    
    132,487
    
    
    
    120,154
    
    
    
    12,333
    
    
    
    $
    2,676,953
    
    
    $
    2,417,202
    
    
    
    259,751
    
    
    
    174,383Other assets, net of other liabilities
    
    
    
    
    
    
    
    
    
    
    40,974
    
    
    
    2,896
    (b)First quarter common dividend
    
    
    
    
    
    
    
    
    
    
    (7,807
    )
    
    
    (7,807
    )(c)Liquidity reserves for funding principal
payments and margin calls
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (130,006
    )(d)$
    292,918
    
    
    $
    39,466Balances 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 March 31, 2004, adjusted separately for
liquidity reserves.(b)
    
    Represents unrestricted cash and cash equivalents.(c)
    
    The first quarter 2004 common dividend was declared March 11, 2004 and
paid April 21, 2004 to stockholders of record as of March 31, 2004.(d)
    
    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. -19-




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##### Table of Contents



The Company generally finances its mortgage securities and similar investments
with well-established investment banking firms using repurchase arrangements
and similar borrowings. Assuming potential liquidity is available, these
borrowings can be increased or decreased on a daily basis to meet cash flow
requirements and otherwise manage capital resources efficiently. CMO
collateral is pledged to secure CMO bonds. Real estate held for lease is
financed by long-term borrowings. Liquidity is affected by, among other
things, changes in market value of assets pledged under borrowing arrangements,
principal prepayments and general conditions in the investment banking,
mortgage finance and real estate industries. Future levels of financial
leverage will be dependent upon many factors, including the size and
composition of the Companys investment portfolios (see Liquidity and Capital
Resources). -20-




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##### Table of Contents



RESULTS OF OPERATIONS Comparative net operating results (interest income or lease revenue, net of
related interest expense and, in the case of CMO administration, related direct
and indirect operating expense) by source were as follows (in thousands, except
per share amounts): Quarter Ended March 312004
    
    2003Mortgage securities and similar investments:Agency Securities
    
    $
    11,673
    
    
    $
    15,786Non-agency Securities
    
    
    1,701
    
    
    
    1,045CMBS and other commercial loans
    
    
    182
    
    
    
    1,014CMO collateral and investments
    
    
    217
    
    
    
    (407
    )Net margin on financial assets
    
    
    13,773
    
    
    
    17,438Real estate held for lease:Lease revenue after related interest expense
    
    
    1,440
    
    
    
    1,429Real estate depreciation
    
    
    (927
    )
    
    
    (927
    )Net margin on real estate held for lease
    
    
    513
    
    
    
    502Other revenue (expense):Gain on asset sales and CMO redemptions
    
    
    
    
    
    
    1,748CMO administration and other
    
    
    67
    
    
    
    220Incentive fee payable to former affiliate
    
    
    
    
    
    
    (303
    )Other operating expense
    
    
    (1,999
    )
    
    
    (2,062
    )Total other revenue (expense)
    
    
    (1,932
    )
    
    
    (397
    )Net income
    
    
    12,354
    
    
    
    17,543Less cash dividends on preferred shares
    
    
    (5,067
    )
    
    
    (5,070
    )Net income available to common stockholders
    
    $
    7,287
    
    
    $
    12,473Operating income *
    
    $
    8,298
    
    
    $
    11,739Net income per common share:Basic
    
    $
    0.51
    
    
    $
    0.90Diluted
    
    
    0.50
    
    
    
    0.75Operating *
    
    
    0.57
    
    
    
    0.82
   *
    
    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 $2.19
(the Series B preferred share annualized dividend of $1.26
divided by the current conversion rate of 0.5742). Because
it is not economically advantageous to convert these shares
at market prices of both the common shares and Series B
preferred shares, few, if any, actual Series B conversions
are expected. Therefore, operating income per common share
excludes the dilutive effects, if present, of the Series B
preferred shares. -21-




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##### Table of Contents



The earning capacity of Capsteads financial asset portfolios is influenced by
the overall size and composition of the portfolios, the relationship between
short- and long-term interest rates (the yield curve) and the extent the
Company continues to invest its liquidity in these portfolios. Net margins on
financial assets and related financing spreads have 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. However, lower
interest rates have also led to declining yields on the Companys
adjustable-rate assets and declining portfolio balances primarily caused by
relatively high mortgage prepayment rates. While financing spreads are
expected to continue declining as yields on the Companys ARM securities
continue resetting lower, the Company has had success recently in replacing
runoff that, if it continues, should slow declines in net margins provided
borrowing rates stay at current levels. See Financial Condition  Overview
and Mortgage Securities and Similar Investments for further discussion of the
current operating environment and the Companys goals regarding redeploying
capital made available by portfolio runoff. Agency Securities remained the primary contributor to operating results during
the quarter ended March 31, 2004; however, the impact of lower financing
spreads was evident in the current quarter results, which were less than in the
same period in 2003 despite lower borrowing rates. Yields for this portfolio
averaged 3.33% during the current quarter, while borrowing rates averaged
1.07%, producing a financing spread of 2.26%. This compares with yields of
4.30% and borrowing rates of 1.30% for a spread of 3.00% during the same period
in 2003. The average outstanding Agency Securities portfolio was $2.0 billion
during the current quarter compared to $2.1 billion during the same period in
2003. Conversely, Non-agency Securities contributed more to operating results during
the quarter ended March 31, 2004 compared to the same period in 2003 primarily
because of the benefits of additional securities made available from the
redemption of CMOs during the latter part of 2003. The average outstanding
portfolio was $188 million during the current quarter compared to $99 million
during the same period in 2003. The portfolio yielded 4.88% during the current
quarter, while borrowing rates averaged 1.52% producing a financing spread of
3.36%. This compares with yields of 4.81% and borrowing rates of 1.41% for a
spread of 3.40% during the same period in 2003. CMBS and other commercial loans contributed significantly less to operating
results during the quarter ended March 31, 2004 than in the same period in 2003
due largely to payoffs during 2003 of several higher yielding investments. The
average outstanding portfolio was $73 million during the current quarter
compared to $142 million during the same period in 2003. The portfolio yielded
2.19% during the current quarter while borrowing rates averaged 1.29% producing
financing spreads of 0.90%. This compares with yields of 4.68% and borrowing
rates of 2.09% for a spread of 2.59% during the same period in 2003. The CMO collateral and investments portfolio has declined significantly the
last several years primarily because of high prepayments on the underlying
pledged CMO collateral and the exercise of Clean-up Calls in which the Company
redeemed the related bonds and either sold the released CMO collateral for
gains or transferred it into the Non-agency Securities portfolio where it is
held for investment. Having redeemed over the past several years nearly all outstanding CMOs to
which the Company holds the related Clean-up Call rights, Capstead did not
realize any gain on asset sales and CMO redemptions in the current quarter. CMO administration revenue continues to trend lower primarily because a
declining portfolio of CMOs for which the Company provides administrative
services. As these CMOs pay down, related fee income is expected to decline.
Other revenue was lower due to lower balances in overnight investments during
the current quarter. -22-




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##### Table of Contents



Other operating expenses (including incentive fees payable to former affiliate)
were lower for the current quarter than during the same period in 2003
primarily because of lower current year accruals for incentive fees. This
reflects lower earnings during the current quarter due primarily to lower
financing spreads and no current period gains on asset sales and CMO
redemptions, as described above. 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 March 31, 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. These
borrowings totaled $2.1 billion at March 31, 2004. Capstead has uncommitted
repurchase facilities with investment banking firms to finance these
investments, subject to certain conditions. Interest rates on these borrowings
are generally based on 30-day London Interbank Offered Rate (LIBOR) (or a
corresponding benchmark rate for longer-term arrangements) and related terms
and conditions are negotiated on a transaction-by-transaction basis. Amounts
available to be borrowed under these arrangements are dependent upon the fair
value of the securities pledged as collateral, which fluctuates with changes in
interest rates, credit quality and liquidity conditions within the investment
banking, mortgage finance and real estate industries. Borrowings under repurchase arrangements with investment banking firms secured
by CMBS more closely match the interest rate adjustment features of these
investments such that the Company anticipates it can earn more consistent
financing spreads and, as a result, experience less interest rate volatility
than experienced with investments in Agency Securities. These borrowings,
which generally have longer initial maturities than borrowings secured by
Agency Securities and may feature renewal options, totaled $69 million at March
31, 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 $129 million at March 31, 2004 and are secured by CMO
collateral pledged to the related indentures. As such, recourse is limited to
this collateral and therefore has a limited impact on Capsteads liquidity and
capital resources. Mortgage prepayments and Clean-up Calls affect the maturity
of each CMO series. With its acquisition of senior living properties in May 2002, Capstead assumed
$19 million in fixed-rate mortgage financing from a commercial bank that
matures in 2009 and $101 million in tax-exempt bond debt. In November 2002,
the tax-exempt bonds were refunded with proceeds from issuing new 30-year -23-




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##### Table of Contents



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 may resume during the second
quarter. The proceeds from future issuances, if any, together with Capsteads
existing liquidity, are available to fund further acquisitions of ARM
securities, if available at attractive prices, and increase the Companys
flexibility in pursuing real estate-related opportunities. EFFECTS OF INTEREST RATE CHANGES Interest Rate Sensitivity on Operating Results Capstead performs earnings sensitivity analysis using an income simulation
model to estimate the effects that specific interest rate changes can
reasonably be expected to have on future earnings. All financial assets and
Derivatives held are included in this analysis. The sensitivity of components
of Other revenue (expense)to changes in interest rates is included as well,
although no asset sales are assumed. Because under the terms of the Lease the
lessee is responsible for changes in related debt service requirements,
earnings from the Companys investment in net-leased real estate are generally
not affected by changes in interest rates. The model incorporates management
assumptions regarding the level of mortgage prepayments for a given interest
rate change using market-based estimates of prepayment speeds for purposes of
amortizing investment and liability premiums and discounts. These assumptions
are developed through a combination of historical analysis and future expected
pricing behavior. Capstead had the following estimated earnings sensitivity
profile as of March 31, 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:March 31, 2004
    
    
    1.09
    %
    
    
    3.84
    %
    
    $
    (1,240
    )
    
    $
    (11,038
    )
    
    $
    (10,409
    )
    
    $
    (23,049
    )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. 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. -24-




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##### Table of Contents



General Discussion of Effects of Interest Rate Changes Changes in interest rates may affect Capsteads earnings in various ways.
Earnings currently depend, in part, on the difference between the interest
received on mortgage securities and similar investments, and the interest paid
on related borrowings, which are generally based on 30-day LIBOR. The
resulting financing spread may be reduced or even turn negative in a rising
short-term interest rate environment. Because the mortgage securities and
similar investments portfolio consists primarily of ARM securities, the risk of
rising short-term interest rates is offset to some extent by increases in the
rates of interest earned on the underlying ARM loans, which reset once or twice
a year based on underlying indices, subject to periodic and lifetime limits,
referred to as caps. The Companys ARM securities featured the following
average coupon rate, and average periodic and lifetime caps as of March 31,
2004 (dollars in thousands): Average
    
    Average
    
    AverageARM Type
    
    Basis *
    
    Coupon Rate
    
    Periodic Cap
    
    Lifetime CapAgency Securities:Fannie Mae/Freddie Mac
    
    $
    1,295,186
    
    
    
    3.56
    %
    
    
    1.744
    %
    
    
    11.239
    %Ginnie Mae
    
    
    839,714
    
    
    
    4.17
    
    
    
    1.000
    
    
    
    10.373Non-agency Securities
    
    
    72,521
    
    
    
    4.01
    
    
    
    1.727
    
    
    
    11.243$
    2,207,421
    
    
    
    3.81
    
    
    
    1.460
    
    
    
    10.910
   *
    
    Basis represents the Companys investment before unrealized
gains and losses. Since only a portion of the ARM loans underlying these securities reset each
month subject to periodic and lifetime caps, interest rates on borrowings can
rise to levels that may exceed the interest rates on the underlying loans,
contributing to lower or even negative financing spreads. At other times,
declines in these indices during periods of relatively low short-term interest
rates will negatively effect yields on ARM securities as the underlying ARM
loans reset at lower rates. If declines in these indices exceed declines in the
Companys borrowing rates, earnings would be adversely affected. The Company
may extend maturity dates on a portion of its short-term borrowings or invest
in Derivatives from time to time as a hedge against rising interest rates.
Subsequent to quarter-end, the Company entered into several longer maturity
repurchase arrangements totaling $200 million with maturities ranging from one
and one-half to two years. As of April 30, 2004, 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 a rate of return at least equal to the rate previously earned
on that capital, earnings may be adversely affected. There can be no assurance
that suitable investments at attractive pricing will be available on a timely
basis to replace runoff as it occurs or that the current composition of
investments (consisting primarily of ARM Agency Securities) will be maintained. Capstead periodically sells assets, which may increase income volatility
because of the recognition of transactional gains or losses. Such sales may
become attractive as asset values fluctuate with changes in interest rates. At
other times, asset sales may become prudent to shift the Companys investment
focus. During periods of rising interest rates or contracting market
liquidity, asset values can decline, leading to increased margin calls and
reducing the Companys liquidity. A margin call means that a lender requires a
borrower to pledge additional collateral to re-establish the agreed-upon ratio
of the value of the collateral 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. -25-




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RISKS ASSOCIATED WITH CREDIT-SENSITIVE INVESTMENTS Commercial mortgage assets may be viewed as exposing an investor to greater
risk of loss than residential mortgage assets since such assets are typically
secured by larger loans to fewer obligors than residential mortgage assets.
Commercial property values and related net operating income are often subject
to volatility, and net operating income may be sufficient or insufficient to
cover debt service on the related mortgage loan at any given time. The
repayment of loans secured by income-producing properties is typically
dependent upon the successful operation of the related real estate project and
the ability of the applicable property to produce net operating income rather
than upon the liquidation value of the underlying real estate. Even when the
current net operating income is sufficient to cover debt service, there can be
no assurance that this will continue to be the case in the future. Additionally, commercial properties may not be readily convertible to
alternative uses if such properties were to become unprofitable due to
competition, age of improvements, decreased demand, regulatory changes or other
factors. The conversion of commercial properties to alternate uses often
requires substantial capital expenditures, which may or may not be available. The availability of credit for commercial mortgage loans may be dependent upon
economic conditions in the markets where such properties are located, as well
as the willingness and ability of lenders to make such loans. The availability
of funds in the credit markets fluctuates and there can be no assurance that
the availability of such funds will increase above, or will not contract below
current levels. In addition, the availability of similar commercial
properties, and the competition for available credit, may affect the ability of
potential purchasers to obtain financing for the acquisition of properties.
This could effect the repayment of commercial mortgages. Credit-sensitive residential mortgage assets differ from commercial mortgage
assets in several important ways yet can still carry substantial credit risk.
Residential mortgage securities typically are secured by smaller loans to more
obligors than CMBS, thus spreading the risk of mortgagor default. However,
most of the mortgages supporting credit-sensitive residential securities are
made to homeowners that do not qualify for Agency loan programs for reasons
including loan size, financial condition, or work or credit history that may be
indicative of higher risk of default than loans qualifying for such programs.
As with 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. -26-




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RISKS ASSOCIATED WITH OWNING REAL ESTATE The direct ownership of commercial real estate involves a number of risks.
With its first acquisition of real estate, Capstead has attempted to mitigate
these risks by entering into a long-term net-lease arrangement whereby the
lessee is responsible for the ongoing operation and management of the
properties and for paying all expenses associated with the operation of the
properties. Although reduced by this net-lease arrangement, risks of ownership
remain, including:  
    
    The risk that changes in economic conditions or real estate markets may adversely affect the value of the properties.
    
    During inflationary periods, which are generally accompanied by rising interest rates, increases in operating costs and
borrowing rates may be greater than increases in lessee revenues from operating properties. Over an extended period of
time, this could result in lessee defaults.
    
    The risk that a deterioration of local conditions could adversely affect the ability of a lessee to profitably operate a
property. For instance, an oversupply of senior living properties could hamper the leasing of senior living units at
favorable rates. This could ultimately affect the value of the properties.
    
    Changes in tax, zoning or other laws could make properties less attractive or less profitable.
    
    An owner cannot be assured that lessees will elect to renew their leases when the terms expire. If a lessee does not renew
its lease or otherwise defaults on its lease obligations, there is no assurance the owner can obtain a substitute lessee on
acceptable terms. If the owner cannot obtain another qualified operator to lease a property, the owner may be required to
modify the property for a different use, which may involve significant capital expenditures and delays in re-leasing the
property.
    
    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 -27-




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with future requirements may involve significant unanticipated expenditures.
Although typically these expenditures would be the responsibility of the
lessee under the terms of net-leases, if lessees fail to perform these
obligations, the owner may be required to do so.
    
    Under federal, state and local environmental laws, the owner may be
required to investigate and clean up any release of hazardous or toxic
substances or petroleum products at its properties, regardless of its
knowledge or actual responsibility, simply because of current or past
ownership of the real estate. If unidentified environmental problems
arise, the owner may have to make substantial payments, which could
adversely affect cash flow and the ability to make distributions to
stockholders. This is so because:  1.
    
    The owner may have to pay for property damage and for investigation
and clean-up costs incurred in connection with the contamination.2.
    
    The law may impose clean-up responsibility and liability regardless
of whether the owner or operator knew of or caused the contamination.
Even if more than one person is responsible for the contamination, each
person who shares legal liability under environmental laws may be held
responsible for all of the clean-up costs.3.
    
    Governmental entities and third parties may sue the owner or
operator of a contaminated site for damages and costs. In investigating the acquisition of real estate, environmental studies are
typically performed to establish the existence of any contamination. In
addition, net-leases generally require lessees to operate properties in
compliance with environmental laws and to indemnify the owner against
environmental liability arising from the operation of such properties.  
    
    An owner may desire to sell a property in the future because of changes
in market conditions or poor lessee performance or to avail itself of
other opportunities. An owner may also be required to sell a property in
the future to meet debt obligations or avoid a default. Unlike investments
in mortgage securities, real estate cannot always be sold quickly, and
there can be no assurance that the properties can be sold at a favorable
price or that a prospective buyer will view existing lease or operating
arrangements favorably. In addition, a property may require restoration or
modification before it is sold. INVESTMENT COMPANY ACT OF 1940 The Investment Company Act of 1940, as amended (the Investment Company Act),
exempts entities that are primarily engaged in the business of purchasing or
otherwise acquiring mortgages and other liens on, and interests in, real
estate. Capstead intends to conduct its business so as not to become regulated
as an investment company under the Investment Company Act. If the Company
fails to qualify for this exemption, its ability to use leverage would be
substantially reduced and it would be unable to conduct its business as
described herein. Under the current interpretation of the staff of the Securities and Exchange
Commission (SEC), in order to qualify for this exemption a REIT must maintain
at least 55% of its assets directly in qualifying real estate interests.
Mortgage-backed securities that do not represent all of the certificates issued
with respect to an underlying pool of mortgages (Non-whole Pool Securities)
may be treated as separate from the underlying mortgage loans and, thus, may
not qualify for purposes of the 55% requirement. Therefore, the provisions of
the Investment Company Act limit ownership of these mortgage-backed securities. -28-




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In satisfying the 55% requirement under the Investment Company Act, a REIT may
treat mortgage-backed securities issued with respect to an underlying pool to
which it holds all issued certificates (Whole Pool Securities) as qualifying
real estate interests. If the SEC or its staff adopts a contrary
interpretation of such treatment, the REIT could be required to sell a
substantial amount of Non-whole Pool Securities or other non-qualified assets
under potentially adverse market conditions. Further, in order to ensure
continued qualification for the exemption under the Investment Company Act, a
REIT might be precluded from acquiring Non-whole Pool Securities even if their
yield is higher than the yield of Whole Pool Securities. These factors may
lower earnings. CRITICAL ACCOUNTING POLICIES Managements discussion and analysis of financial condition and results of
operations is based upon Capsteads consolidated financial statements, which
have been prepared in accordance with accounting principles generally accepted
in the United States. The preparation of these financial statements requires
the use of estimates and judgments that can affect the reported amounts of
assets, liabilities (including contingencies), revenues and expenses as well as
related disclosures. These estimates are based on available internal and
market information and appropriate valuation methodologies believed to be
reasonable under the circumstances, the results of which form the basis for
making judgments about the expected useful lives and carrying values of assets
and liabilities which can materially affect the determination of net income and
book value per common share. Actual results may differ from these estimates
under different assumptions or conditions. Management believes the following are critical accounting policies in the
preparation of Capsteads consolidated financial statements that involve the
use of estimates requiring considerable judgment:  
    
    Amortization of Premiums and Discounts on Financial Assets and
Borrowings Premiums and discounts on financial assets and borrowings
are recognized in earnings as adjustments to interest income or
interest expense by the interest method over the estimated lives of
the related assets or borrowings. For most of Capsteads financial
assets, and for its CMO borrowings, 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 of the Companys real estate
properties have become impaired. If estimated operating cash flows -29-




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(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. 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 EndedMarch 31, 2004
    
    March 31, 2003Operating
    
    Diluted
    
    Operating
    
    DilutedNet income
    
    $
    12,354
    
    
    $
    12,354
    
    
    $
    17,543
    
    
    $
    17,543Adjustments for:Depreciation on real estate
    
    
    927
    
    
    
    
    
    
    
    927
    
    
    
    Gain on asset sales and
CMO redemptions
    
    
    
    
    
    
    
    
    
    
    (1,748
    )
    
    
    Series B preferred dividends
    
    
    (4,983
    )
    
    
    (4,983
    )
    
    
    (4,983
    )
    
    
    $
    8,298
    
    
    $
    7,371
    
    
    $
    11,739
    
    
    $
    17,543Weighted average common
shares outstanding
    
    
    14,267
    
    
    
    14,267
    
    
    
    13,935
    
    
    
    13,935Net effect of dilutive
securities:Preferred B shares
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    8,910Stock options and other
preferred shares
    
    
    353
    
    
    
    353
    
    
    
    407
    
    
    
    40714,620
    
    
    
    14,620
    
    
    
    14,342
    
    
    
    23,252$
    0.57
    
    
    $
    0.50
    
    
    $
    0.82
    
    
    $
    0.75
 -30-




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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 March 31, 2004, an evaluation was performed under the supervision and
with the participation of the Companys management, including the CEO and Chief
Financial Officer (CFO), of the effectiveness of the design and operation of
the Companys disclosure controls and procedures. Based on that evaluation,
the Companys management, including the CEO and CFO, concluded that the
Companys disclosure controls and procedures were effective as of March 31,
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 March 31, 2004. 
 PART II.  OTHER INFORMATION 
 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS  (a)
    
    The annual meeting of stockholders was held April 22, 2004.(b)
    
    The board members included in (c) below were elected to Capsteads Board
of Directors (constituting the entire Board of Directors).(c)
    
    The following items were voted on at the annual meeting: Withheld/
    
    BrokerFor
    
    Against
    
    Abstentions
    
    Non-votes
    
    Election of board members:Andrew F. Jacobs
    
    
    13,301,700
    
    
    
    
    
    
    
    335,707
    
    
    
    Gary Keiser
    
    
    13,255,364
    
    
    
    
    
    
    
    382,043
    
    
    
    Paul M. Low
    
    
    13,272,371
    
    
    
    
    
    
    
    365,036
    
    
    
    Michael G. O'Neil
    
    
    13,314,001
    
    
    
    
    
    
    
    232,406
    
    
    
    Howard Rubin
    
    
    13,268,906
    
    
    
    
    
    
    
    368,501
    
    
    
    Mark S. Whiting
    
    
    13,273,947
    
    
    
    
    
    
    
    363,460
    
    
    
    
    
    Ratify Appointment of Ernst &
Young LLP as Independent Auditors
    
    
    13,351,845
    
    
    
    145,670
    
    
    
    139,692
    
    
    
    
    
    Approval of the 2004 Flexible Long-Term Incentive Plan
    
    
    5,524,979
    
    
    
    1,483,808
    
    
    
    360,307
    
    
    
    6,268,313
    
    Other matters (no other matters)
 -31-




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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 January 28, 2004 announcing fourth quarter
2003 financial results, record date for Annual Meeting of Stockholders and
common dividend schedule for 2004.Current Report on Form 8-K dated April 22, 2004 announcing first quarter
2004 financial results. 
 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:  May 4, 2004
    By:
    /s/ ANDREW F. JACOBSAndrew F. JacobsPresident and Chief Executive Officer Date:  May 4, 2004
    By:
    /s/ PHILLIP A. REINSCHPhillip A. ReinschSenior Vice President and
Chief Financial Officer -32-