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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, 2005ORo
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the transition period from ___to ___ Commission File Number: 1-8996 CAPSTEAD MORTGAGE CORPORATION  Maryland
    
    75-2027937(State or other jurisdiction of
    
    (I.R.S. Employerincorporation or organization)
    
    Identification No.)
 8401 North Central Expressway, Suite 800, Dallas, TX
    
    75225(Address of principal executive offices)
    
    (Zip Code)
 Registrants telephone number, including area code: (214) 874-2323 Indicate by check mark whether the Registrant (1) has filed all documents and reports required to
be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12
months (or for such shorter period that the Registrant was required to file such reports), and (2)
has been subject to such filing requirements for the past 90 days. YES 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)
    
    18,870,697 as of April 26, 2005




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CAPSTEAD MORTGAGE CORPORATION
FORM 10-Q
FOR THE QUARTER ENDED MARCH 31, 2005 INDEX PagePART I. 3⁄4 FINANCIAL INFORMATIONITEM 1. Financial StatementsConsolidated Balance Sheets 3⁄4 March 31, 2005 and December 31, 2004
    
    
    3Consolidated Statements of Operations 3⁄4 Quarter Ended March 31, 2005 and 2004
    
    
    4Consolidated Statements of Cash Flows 3⁄4 Quarter Ended March 31, 2005 and 2004
    
    
    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
    
    
    32PART II. 3⁄4 OTHER INFORMATIONITEM 4. Submission of Matters to a Vote of Security Holders
    
    
    32ITEM 6. Exhibits and Reports on Form 8-K
    
    
    32SIGNATURES
    
    
    33Computation of Ratio of Earnings to Combined Fixed Charges and Preferred Stock DividendsCertification Pursuant to Section 302Certification Pursuant to Section 302Certification Pursuant to Section 906
 -2-




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ITEM 1. FINANCIAL STATEMENTS 
 PART I. 3⁄4 FINANCIAL INFORMATION CAPSTEAD MORTGAGE CORPORATION 
 CONSOLIDATED BALANCE SHEETS
 (in thousands, except per share amounts)
 March 31, 2005
    
    
    December 31, 2004(unaudited)
    
    
    (NOTE 2)AssetsMortgage securities and similar investments
($3.3 billion pledged under repurchase arrangements in 2005)
    
    $
    3,410,391
    
    
    $
    3,382,372CMO collateral
    
    
    29,244
    
    
    
    56,1873,439,635
    
    
    
    3,438,559Real estate held for lease, net of accumulated depreciation
    
    
    128,778
    
    
    
    129,705Receivables and other assets
    
    
    46,871
    
    
    
    46,688Cash and cash equivalents
    
    
    4,079
    
    
    
    73,030$
    3,619,363
    
    
    $
    3,687,982LiabilitiesRepurchase arrangements and similar borrowings
    
    $
    3,132,897
    
    
    $
    3,166,059Collateralized mortgage obligations (CMOs)
    
    
    28,886
    
    
    
    55,735Borrowings secured by real estate
    
    
    119,941
    
    
    
    120,001Common stock dividend payable
    
    
    3,397
    
    
    
    4,151Accounts payable and accrued expenses
    
    
    7,665
    
    
    
    9,4973,292,786
    
    
    
    3,355,443Stockholders equityPreferred stock  $0.10 par value; 100,000 shares authorized:$1.60 Cumulative Preferred Stock, Series A,
202 shares issued and outstanding at
March 31, 2005 and December 31, 2004
($3,317 aggregate liquidation preference)
    
    
    2,827
    
    
    
    2,827$1.26 Cumulative Convertible Preferred Stock, Series B,
15,819 shares issued and outstanding at
March 31, 2005 and December 31, 2004
($180,025 aggregate liquidation preference)
    
    
    176,705
    
    
    
    176,705Common stock  $0.01 par value; 100,000 shares authorized;
18,871 and 18,867 shares issued and outstanding at
March 31, 2005 and December 31, 2004, respectively
    
    
    189
    
    
    
    189Paid-in capital
    
    
    515,910
    
    
    
    516,704Accumulated deficit
    
    
    (387,718
    )
    
    
    (387,718
    )Accumulated other comprehensive income
    
    
    18,664
    
    
    
    23,832326,577
    
    
    
    332,539$
    3,619,363
    
    
    $
    3,687,982
 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 312005
    
    
    2004Interest income:Mortgage securities and similar investments
    
    $
    28,181
    
    
    $
    19,437CMO collateral
    
    
    342
    
    
    
    2,506Total interest income
    
    
    28,523
    
    
    
    21,943Interest and related expense:Repurchase arrangements and similar borrowings
    
    
    19,739
    
    
    
    5,830CMO borrowings
    
    
    244
    
    
    
    2,293Mortgage insurance and other
    
    
    50
    
    
    
    47Total interest and related expense
    
    
    20,033
    
    
    
    8,170Net margin on financial assets
    
    
    8,490
    
    
    
    13,773Real estate lease income
    
    
    2,650
    
    
    
    2,525Real estate-related expense:Interest
    
    
    1,277
    
    
    
    1,085Depreciation
    
    
    927
    
    
    
    927Total real estate-related expense
    
    
    2,204
    
    
    
    2,012Net margin on real estate held for lease
    
    
    446
    
    
    
    513Other revenue (expense):CMO administration and other
    
    
    196
    
    
    
    67Other operating expense
    
    
    (1,530
    )
    
    
    (1,999
    )Total other revenue (expense)
    
    
    (1,334
    )
    
    
    (1,932
    )Net income
    
    $
    7,602
    
    
    $
    12,354Net income
    
    $
    7,602
    
    
    $
    12,354Less cash dividends paid on preferred shares
    
    
    (5,064
    )
    
    
    (5,067
    )Net income available to common stockholders
    
    $
    2,538
    
    
    $
    7,287Net income per common share:Basic
    
    $
    0.13
    
    
    $
    0.51Diluted
    
    
    0.13
    
    
    
    0.50Cash dividends declared per share:Common
    
    $
    0.180
    
    
    $
    0.530Series 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 312005
    
    
    2004Operating activities:Net income
    
    $
    7,602
    
    
    $
    12,354Noncash items:Amortization of discount and premium
    
    
    4,879
    
    
    
    2,009Depreciation and other amortization
    
    
    1,112
    
    
    
    1,160Net change in receivables, other assets,
accounts payable and accrued expenses
    
    
    (1,425
    )
    
    
    (1,700
    )Net cash provided by operating activities
    
    
    12,168
    
    
    
    13,823Investing activities:Purchases of mortgage securities and similar investments
    
    
    (302,735
    )
    
    
    (368,700
    )Principal collections on mortgage securities
and similar investments
    
    
    263,916
    
    
    
    148,054CMO collateral:Principal collections
    
    
    26,251
    
    
    
    37,757Decrease in accrued interest receivable
    
    
    206
    
    
    
    233Net cash used in investing activities
    
    
    (12,362
    )
    
    
    (182,656
    )Financing activities:Net (decrease) increase in repurchase arrangements
and similar borrowings
    
    
    (33,162
    )
    
    
    193,241Principal payments on borrowings secured by real estate
    
    
    (60
    )
    
    
    (52
    )CMO borrowings:Principal payments on securities
    
    
    (26,166
    )
    
    
    (37,563
    )Decrease in accrued interest payable
    
    
    (189
    )
    
    
    (218
    )Capital stock transactions
    
    
    35
    
    
    
    13,877Dividends paid
    
    
    (9,215
    )
    
    
    (13,896
    )Net cash (used in) provided by financing activities
    
    
    (68,757
    )
    
    
    155,389Net change in cash and cash equivalents
    
    
    (68,951
    )
    
    
    (13,444
    )Cash and cash equivalents at beginning of period
    
    
    73,030
    
    
    
    16,340Cash and cash equivalents at end of period
    
    $
    4,079
    
    
    $
    2,896
 See accompanying notes to consolidated financial statements. -5-




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CAPSTEAD MORTGAGE CORPORATION 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2005
 (unaudited)
 NOTE 1 3⁄4 BUSINESS Capstead Mortgage Corporation (together with its subsidiaries, Capstead or the Company)
operates as a real estate investment trust (REIT) earning income from investing in real
estate-related assets on a leveraged basis and from other investment strategies. These investments
primarily consist of, but are not limited to, residential financial assets, specifically
adjustable-rate mortgage (ARM) securities issued and guaranteed by government-sponsored entities,
either Fannie Mae or Freddie Mac, or by an agency of the federal government, Ginnie Mae
(collectively, Agency Securities). Capstead has also made limited investments in
credit-sensitive commercial real estate-related assets, including the direct ownership of real
estate. Management believes such investments, when available at favorable prices and combined with
the prudent use of leverage, can produce attractive risk-adjusted returns over the long term with
relatively low sensitivity to changes in interest rates. The earning capacity of Capsteads financial asset portfolios is influenced by the overall size and
composition of the portfolios, which depends on investment strategies being implemented by
management, the availability of attractively-priced investments and overall market conditions.
Market conditions are influenced by, among other things, current levels of, and expectations for
future levels of, 30-day to two-year interest rates and mortgage prepayments. Financing spreads
(the difference between yields earned on these investments and interest rates charged on related
borrowings) have declined from the historically wide levels achieved the last several years when
short-term interest rates were lower and are expected to continue declining in 2005 before
beginning to recover once the Federal Reserve slows its pace of raising interest rates. Because
the majority of the Companys financial assets currently consist of ARM securities backed by
mortgage loans with coupon interest rates that reset at least annually, management believes the
Company is well positioned to manage through the currently anticipated higher interest rate
environment, albeit at a lower earnings level than that achieved the last several years when
short-term interest rates were lower. NOTE 2 3⁄4 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, 2005 are not necessarily indicative of the results that may be expected
for the calendar year ending December 31, 2005. 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, 2004. Stock-Based
Compensation
Capstead accounts for stock-based awards for employees and directors under the recognition and
measurement principles of the Accounting Principles Board Opinion No. 25, Accounting for Stock
Issued to Employees, and related Interpretations (APB25). Under APB25 compensation cost for -6-




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stock-based awards for employees and directors is measured as the excess, if any, of the quoted
market price of the Companys stock at the date of grant over the amount to be paid to acquire the
stock and is recognized in Other operating expenseas the awards vest and restrictions lapse on a
straight-line basis. If the Company had expensed stock-based compensation costs determined using
the fair value-based methodology prescribed by Statement of Financial Accounting Standards No. 123
Accounting for Stock-based Compensation (SFAS 123), such expense would have been higher by less
than $11,000 for the three months ended March 31, 2005 and 2004, respectively, which would have had
no effect on reported diluted net income per common share for the periods presented. In December 2004 the Financial Accounting Standards Board revised SFAS 123 to supercede APB25 and
require the use of a fair value-based methodology (similar to the original SFAS 123 methodology) to
measure and record liabilities associated with stock-based compensation. The revised standard is
required to be adopted by Capstead beginning January 1, 2006 and is applicable to any new awards
and to all existing awards for which the requisite service to earn the award has not yet been
rendered. The effect of adopting the revised standard is not expected to be material to Capsteads
earnings or financial condition. NOTE 3 3⁄4 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, if any, 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 312005
    
    
    2004Numerator for basic net income per common share:Net income
    
    $
    7,602
    
    
    $
    12,354Less all preferred share dividends
    
    
    (5,064
    )
    
    
    (5,067
    )Net income available to common stockholders
    
    $
    2,538
    
    
    $
    7,287Weighted average common shares outstanding
    
    
    18,860
    
    
    
    14,267Basic net income per common share
    
    $
    0.13
    
    
    $
    0.51Numerator for diluted net income per common share:Net income
    
    $
    7,602
    
    
    $
    12,354Less dividends on antidilutive convertible preferred shares
    
    
    (5,064
    )
    
    
    (4,983
    )$
    2,538
    
    
    $
    7,371Denominator for diluted net income per common share:Weighted average common shares outstanding
    
    
    18,860
    
    
    
    14,267Net effect of dilutive stock options
    
    
    25
    
    
    
    39Net effect of dilutive Series A preferred shares
    
    
    
    
    
    
    31418,885
    
    
    
    14,620Diluted net income per common share
    
    $
    0.13
    
    
    $
    0.50
 For dilutive net income per common share purposes, the Series A and B preferred shares are
considered dilutive whenever annualized basic net income per common share exceeds each Series
annualized dividend divided by the conversion rate applicable for that period. -7-




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NOTE 4 3⁄4 MORTGAGE SECURITIES AND SIMILAR INVESTMENTS The Company classifies its investments in mortgage securities and similar financial assets by
collateral type and interest rate characteristics. Agency Securities are AAA-rated and are
considered to have limited credit risk. Non-agency securities consist of private mortgage
pass-through securities originally formed prior to 1995 when the Company operated a mortgage
conduit. These securities are backed by residential mortgage loans whereby the related credit risk
of the underlying loans is either borne by AAA-rated private mortgage insurers or by the Company
(Non-agency Securities). Included in Receivables and other assetsas restricted cash at March
31, 2005 was $6.0 million in related reserve funds for special hazards (e.g. earthquake or
mudslide-related losses) and certain bankruptcy losses. Commercial mortgage securitizations
generally have senior, mezzanine and subordinate classes of bonds with the lower bond classes
providing credit enhancement to the more senior classes. Commercial mortgage-backed securities
(CMBS) held by the Company as of March 31, 2005 are mezzanine classes and therefore carry credit
risk associated with the underlying pools of commercial mortgage loans that is mitigated by
subordinate bonds held by other investors. The maturity of mortgage securities is directly
affected by the rate of principal prepayments on the underlying loans. Fixed-rate investments generally are mortgage securities backed by mortgage loans that have fixed
rates of interest over the life of the loans. Adjustable-rate investments generally are mortgage
securities backed by mortgage loans that have interest rates that adjust at least annually to more
current interest rates (current-reset ARM securities) or begin doing so after an initial
fixed-rate period (longer-to-reset ARM securities). Mortgage loans underlying current-reset ARM
securities either (i) adjust annually based on a specified margin over the one-year Constant
Maturity U.S. Treasury Note Rate or the one-year London Interbank Offered Rate (LIBOR), (ii)
adjust semiannually based on a specified margin over six-month LIBOR, or (iii) adjust monthly based
on a specific margin over an index such as LIBOR or the Eleventh District Federal Reserve Bank Cost
of Funds Index, usually subject to periodic and lifetime limits on the amount of such adjustments
during any single interest rate adjustment period and over the life of the loan. Mortgage loans
underlying longer-to-reset ARM securities have initial fixed rates of interest of three to ten
years before beginning to adjust in rate as described above. The average period until initial
reset for the $517 million in longer-to-reset ARM securities held by the Company as of March 31,
2005 was 26 months compared to less than 6 months to the next reset date for the Companys
current-reset ARM securities. CMBS held as of March 31, 2005 adjust monthly based on a specified
margin over 30-day LIBOR. Mortgage securities and similar investmentsand related weighted average
rates were as follows (dollars in thousands): Average
    
    
    AveragePrincipal
    
    
    Premiums
    
    
    
    
    
    
    Carrying
    
    
    Coupon
    
    
    EffectiveBalance
    
    
    (Discounts)
    
    
    Basis
    
    
    Amount(a)
    
    
    Rate(b)
    
    
    Rate(b)March 31, 2005Agency Securities:Fannie Mae/Freddie Mac:Fixed-rate
    
    $
    30,702
    
    
    $
    126
    
    
    $
    30,828
    
    
    $
    30,875
    
    
    
    6.63
    %
    
    
    6.09
    %ARMs
    
    
    2,165,462
    
    
    
    40,628
    
    
    
    2,206,090
    
    
    
    2,215,242
    
    
    
    4.14
    
    
    
    3.32Ginnie Mae ARMs
    
    
    1,014,943
    
    
    
    6,949
    
    
    
    1,021,892
    
    
    
    1,030,909
    
    
    
    3.84
    
    
    
    3.153,211,107
    
    
    
    47,703
    
    
    
    3,258,810
    
    
    
    3,277,026
    
    
    
    4.06
    
    
    
    3.29Non-agency Securities:Fixed-rate
    
    
    29,635
    
    
    
    11
    
    
    
    29,646
    
    
    
    29,683
    
    
    
    6.77
    
    
    
    6.15ARMs
    
    
    51,658
    
    
    
    548
    
    
    
    52,206
    
    
    
    52,643
    
    
    
    4.39
    
    
    
    3.8781,293
    
    
    
    559
    
    
    
    81,852
    
    
    
    82,326
    
    
    
    5.26
    
    
    
    4.72CMBS  adjustable-rate
    
    
    50,998
    
    
    
    9
    
    
    
    51,007
    
    
    
    51,039
    
    
    
    3.84
    
    
    
    3.61$
    3,343,398
    
    
    $
    48,271
    
    
    $
    3,391,669
    
    
    $
    3,410,391
    
    
    
    4.09
    
    
    
    3.33
 -8-




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Average
    
    
    AveragePrincipal
    
    
    Premiums
    
    
    
    
    
    
    Carrying
    
    
    Coupon
    
    
    EffectiveBalance
    
    
    (Discounts)
    
    
    Basis
    
    
    Amount(a)
    
    
    Rate(b)
    
    
    Rate(b)December 31, 2004Agency Securities:Fannie Mae/Freddie Mac:Fixed-rate
    
    $
    35,538
    
    
    $
    146
    
    
    $
    35,684
    
    
    $
    35,739
    
    
    
    6.63
    %
    
    
    6.19
    %ARMs
    
    
    2,116,454
    
    
    
    39,572
    
    
    
    2,156,026
    
    
    
    2,170,766
    
    
    
    3.96
    
    
    
    3.11Ginnie Mae ARMs
    
    
    1,017,517
    
    
    
    7,583
    
    
    
    1,025,100
    
    
    
    1,033,506
    
    
    
    3.87
    
    
    
    3.013,169,509
    
    
    
    47,301
    
    
    
    3,216,810
    
    
    
    3,240,011
    
    
    
    3.96
    
    
    
    3.11Non-agency Securities:Fixed-rate
    
    
    34,338
    
    
    
    24
    
    
    
    34,362
    
    
    
    34,415
    
    
    
    6.78
    
    
    
    6.27ARMs
    
    
    55,615
    
    
    
    646
    
    
    
    56,261
    
    
    
    56,739
    
    
    
    4.12
    
    
    
    3.4989,953
    
    
    
    670
    
    
    
    90,623
    
    
    
    91,154
    
    
    
    5.14
    
    
    
    4.55CMBS  adjustable-rate
    
    
    51,159
    
    
    
    10
    
    
    
    51,169
    
    
    
    51,207
    
    
    
    3.44
    
    
    
    3.10$
    3,310,621
    
    
    $
    47,981
    
    
    $
    3,358,602
    
    
    $
    3,382,372
    
    
    
    3.98
    
    
    
    3.16
   (a)
    
    Includes mark-to-market for securities classified as available-for-sale, if applicable
(see NOTE 10).(b)
    
    Average Coupon Rate is presented net of servicing and other fees as of the indicated balance
sheet date. Average Effective Rate is presented for the quarter then ended, calculated
including the amortization of premiums (discounts), mortgage insurance costs on Non-agency
Securities and excluding unrealized gains and losses. NOTE 5 3⁄4 CMO COLLATERAL AND INVESTMENTS Collateral pledged to secure CMOs consists of Non-agency Securities and related accrual interest
and short-term investments. The components of CMO collateralwere as follows (in thousands): March 31, 2005
    
    
    December 31, 2004Non-agency Securities
    
    $
    28,673
    
    
    $
    54,996Accrued interest receivable
    
    
    184
    
    
    
    39028,857
    
    
    
    55,386Unamortized premium
    
    
    387
    
    
    
    801$
    29,244
    
    
    $
    56,187
 Credit risk associated with this collateral is borne by AAA-rated private mortgage insurers or
subordinated bonds within the related CMO series to which the collateral is pledged, none of which
were retained by the Company. The related weighted average effective interest rate was 3.26%
during the quarter ended March 31, 2005. NOTE 6 3⁄4 REAL ESTATE HELD FOR LEASE In May 2002 Capstead acquired six independent senior living facilities wherein the operator of
the facility provides tenants little, if any, medical care (collectively, the Properties). The
aggregate purchase price of the Properties was $139.7 million including approximately $3.1 million
in closing costs and the assumption by Capstead of $19.7 million of related mortgage debt and
$101.1 million of tax-exempt bond debt. The Properties were acquired pursuant to purchase
agreements initially negotiated and executed by an affiliate of Brookdale Living Communities, Inc.
(collectively with its subsidiaries, Brookdale) and subsequently assigned to Capstead.
Concurrent with the acquisition, the Company entered into a long-term net-lease arrangement with
Brookdale, under which Brookdale is responsible for the ongoing operation and management of the
Properties. Brookdale, an owner, operator, -9-




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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. Fortress is
a former affiliate of the Company. The lease arrangement consists of a master lease covering all of the Properties and individual
property-level leases (referred to collectively as the Lease). The Lease has an initial term of
20 years and provides for two 10-year renewal periods. Beginning May 1, 2007, Brookdale will have
the option of purchasing all of the Properties from Capstead at the greater of fair value or
Capsteads original cost, after certain adjustments. Brookdale is responsible for paying all
expenses associated with the operation of the Properties, including real estate taxes, other
governmental charges, insurance, utilities and maintenance, and an amount representing an
attractive cash return on Capsteads equity in the Properties after payment of monthly debt
service, subject to annual increases based upon increases (capped at 3%) in the Core Consumer Price
Index. Brookdale is responsible for changes in related debt service requirements under the terms
of the Lease; therefore, earnings from this investment are generally not affected by changes in
interest rates. Included in Receivables and other assetsat March 31, 2005 was $2.9 million in
unamortized rent abatements and $1.2 million of rent and other receivables due from Brookdale.
Carrying amounts of the Properties were as follows (in thousands): March 31, 2005
    
    
    December 31, 2004Land
    
    $
    16,450
    
    
    $
    16,450Buildings
    
    
    119,550
    
    
    
    119,550Equipment and fixtures
    
    
    3,600
    
    
    
    3,600139,600
    
    
    
    139,600Accumulated depreciation
    
    
    (10,822
    )
    
    
    (9,895
    )$
    128,778
    
    
    $
    129,705
 NOTE 7 3⁄4 REPURCHASE ARRANGEMENTS AND SIMILAR BORROWINGS Capstead borrows under uncommitted repurchase arrangements with well-established investment banking
firms. Repurchase arrangements pursuant to which the Company pledges mortgage securities as
collateral generally have maturities of less than 31 days, although the Company has extended
maturities for up to two years on a portion of its borrowings primarily related to the Companys
modest position in fixed-rate and longer-to-reset ARM securities. From time to time the Company
may obtain similar borrowings from other parties such as commercial banks to finance investments in
financial assets that are not mortgage-backed securities. The terms and conditions of repurchase
arrangements and any similar borrowings are negotiated on a transaction-by-transaction basis.
These borrowings consisted solely of repurchase arrangements as of March 31, 2005. Related
weighted average interest rates, classified by type of collateral and maturities, were as follows
for the dates indicated (dollars in thousands): March 31, 2005
    
    
    December 31, 2004Borrowings
    
    
    Average
    
    
    Borrowings
    
    
    AverageOutstanding
    
    
    Rate
    
    
    Outstanding
    
    
    RateAgency Securities (less than 31 days)
    
    $
    2,343,782
    
    
    
    2.77
    %
    
    $
    2,340,755
    
    
    
    2.28
    %Agency Securities (31 to 90 days)
    
    
    
    
    
    
    
    
    
    
    54,021
    
    
    
    1.98Agency Securities (91 to 360 days)
    
    
    374,973
    
    
    
    2.37
    
    
    
    204,983
    
    
    
    2.19Agency Securities (greater than 360 days)
    
    
    301,754
    
    
    
    2.68
    
    
    
    446,744
    
    
    
    2.61Non-agency Securities (less than 31 days)
    
    
    64,174
    
    
    
    3.18
    
    
    
    71,140
    
    
    
    2.76CMBS (less than 31 days)
    
    
    48,214
    
    
    
    2.89
    
    
    
    48,416
    
    
    
    2.54$
    3,132,897
    
    
    
    2.73
    
    
    $
    3,166,059
    
    
    
    2.33
 -10-




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##### Table of Contents



The weighted average effective interest rate on Repurchase arrangements and similar borrowingswas
2.52% during the quarter ended March 31, 2005. NOTE 8 3⁄4 CMO BORROWINGS Each series of CMOs issued consists of various classes of fixed-rate and adjustable-rate bonds.
Interest is payable monthly at specified rates for all classes. The components of CMOs, along with
selected other information, were as follows for the dates indicated (dollars in thousands): March 31, 2005
    
    
    December 31, 2004CMOs
    
    $
    28,487
    
    
    $
    54,739Accrued interest payable
    
    
    103
    
    
    
    292Total obligation
    
    
    28,590
    
    
    
    55,031Unamortized premium
    
    
    296
    
    
    
    704$
    28,886
    
    
    $
    55,735Range of average interest rates
    
    
    3.21% to 8.45
    %
    
    
    2.29% to 9.60
    %Range of stated maturities
    
    
    2025 to 2028
    
    
    
    2025 to 2030Number of series
    
    
    4
    
    
    
    5
 Typically, principal payments on each series are made to each class in the order of their stated
maturities so that no payment of principal is made on any class of bonds until all classes having
an earlier stated maturity have been paid in full. The maturity of each CMO series is directly
affected by the rate of principal prepayments on the related CMO collateral. Each series is also
subject to redemption provided certain requirements specified in the related indenture have been
met (referred to as Clean-up Calls); therefore, the actual maturity of any series is likely to
occur earlier than its stated maturity. The weighted average effective interest rate for CMO
borrowingswas 2.33% during the quarter ended March 31, 2005. NOTE 9 3⁄4 BORROWINGS SECURED BY REAL ESTATE The components of Borrowings secured by real estateand related weighted average interest rates
(calculated including bond issue cost amortization) were as follows for the dates indicated
(dollars in thousands): March 31, 2005
    
    December 31, 2004Borrowings
    
    
    Average
    
    
    Borrowings
    
    
    AverageOutstanding
    
    
    Rate
    
    
    Outstanding
    
    
    RateMortgage borrowings
    
    $
    19,100
    
    
    
    7.92
    %
    
    $
    19,160
    
    
    
    7.92
    %Tax-exempt bonds
    
    
    100,841
    
    
    
    3.30
    
    
    
    100,841
    
    
    
    2.98$
    119,941
    
    
    
    4.03
    
    
    $
    120,001
    
    
    
    3.77
 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. Monthly interest rate cap and principal reserve fund payments are made to the trustee
for the purchase of new cap agreements in 2007 and the eventual retirement of the bonds by 2032.
Held in escrow by the bond trustee as of -11-




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##### Table of Contents



March 31, 2005 were a total of $4.5 million in interest rate cap reserves, principal reserves and
repair and replacement reserves. These funds are included in Receivables and other assetsas
restricted cash. Also included in Receivables and other assetsare $2.8 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 4.31% for the quarter ended March 31, 2005. NOTE 10 3⁄4 DISCLOSURES REGARDING FAIR VALUES OF DEBT SECURITIES Fair values of the Companys investments are influenced by changes in, and market expectations for
changes in, interest rates and levels of mortgage prepayments as well as other factors beyond the
control of management. Fluctuations in fair value caused by changes in interest rates are
generally offset in a relatively short period of time because most of the Companys investments
adjust to more current rates at least annually. As of March 31, 2005, $1.4 billion of the
Companys investments in mortgage securities carried unrealized losses totaling $7.3 million
compared to $885 million of securities carried at an unrealized loss of $3.5 million at December
31, 2004. Given that managing a large portfolio of mortgage securities remains the core focus of
Capsteads investment strategy, it is likely that these securities will be held to maturity.
Consequently, temporary declines in value because of increases in interest rates would not
constitute other-than-temporary impairments in value necessitating writedowns, absent a major shift
in the Companys investment focus. 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, 2005Agency Securities:Fixed-rate
    
    $
    546
    
    
    $
    47
    
    
    $
    
    
    
    $
    593ARMs
    
    
    3,227,982
    
    
    
    25,469
    
    
    
    7,300
    
    
    
    3,246,1513,228,528
    
    
    
    25,516
    
    
    
    7,300
    
    
    
    3,246,744Non-agency Securities
    
    
    37,774
    
    
    
    507
    
    
    
    33
    
    
    
    38,248CMBS
    
    
    51,007
    
    
    
    33
    
    
    
    1
    
    
    
    51,039CMO collateral
    
    
    10,573
    
    
    
    180
    
    
    
    
    
    
    
    10,753$
    3,327,882
    
    
    $
    26,236
    
    
    $
    7,334
    
    
    $
    3,346,784As of December 31, 2004Agency Securities:Fixed-rate
    
    $
    606
    
    
    $
    55
    
    
    $
    
    
    
    $
    661ARMs
    
    
    3,181,126
    
    
    
    26,467
    
    
    
    3,321
    
    
    
    3,204,2723,181,732
    
    
    
    26,522
    
    
    
    3,321
    
    
    
    3,204,933Non-agency Securities
    
    
    41,166
    
    
    
    564
    
    
    
    33
    
    
    
    41,697CMBS
    
    
    51,169
    
    
    
    39
    
    
    
    1
    
    
    
    51,207CMO collateral
    
    
    12,214
    
    
    
    253
    
    
    
    
    
    
    
    12,467$
    3,286,281
    
    
    $
    27,378
    
    
    $
    3,355
    
    
    $
    3,310,304
 -12-




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##### Table of Contents



Held-to-maturity debt securities consist of CMO collateraland collateral released from the related
CMO indentures pursuant to Clean-up Calls and held as Agency 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, 2005Released CMO Collateral:Agency Securities
    
    $
    30,282
    
    
    $
    1,156
    
    
    $
    
    
    
    $
    31,438Non-agency Securities
    
    
    44,078
    
    
    
    888
    
    
    
    5
    
    
    
    44,961CMO Collateral
    
    
    18,491
    
    
    
    58
    
    
    
    
    
    
    
    18,549$
    92,851
    
    
    $
    2,102
    
    
    $
    5
    
    
    $
    94,948As of December 31, 2004Released CMO Collateral:Agency Securities
    
    $
    35,078
    
    
    $
    1,723
    
    
    $
    
    
    
    $
    36,801Non-agency Securities
    
    
    49,457
    
    
    
    1,345
    
    
    
    97
    
    
    
    50,705CMO Collateral
    
    
    43,720
    
    
    
    84
    
    
    
    
    
    
    
    43,804$
    128,255
    
    
    $
    3,152
    
    
    $
    97
    
    
    $
    131,310
 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. There were no
dispositions of debt securities for the periods presented. NOTE 11 3⁄4 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 312005
    
    
    2004Net income
    
    $
    7,602
    
    
    $
    12,354Other comprehensive income (loss):Unrealized loss on derivative financial instruments
held as cash flow hedges:Change in unrealized loss during period
    
    
    (9
    )
    
    
    (128
    )Reclassification adjustment for amounts
included in net income
    
    
    (38
    )
    
    
    (51
    )(47
    )
    
    
    (179
    )Unrealized gain on debt securities:Change in unrealized gain during period
    
    
    (5,121
    )
    
    
    2,672Other comprehensive income (loss)
    
    
    (5,168
    )
    
    
    2,493Comprehensive income
    
    $
    2,434
    
    
    $
    14,847
 -13-




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##### Table of Contents



NOTE 12 3⁄4 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 312005
    
    
    2004Average
    
    
    
    
    
    
    AverageAmount
    
    
    Rate
    
    
    Amount
    
    
    RateInterest income:Mortgage securities and other investments
    
    $
    28,181
    
    
    
    3.33
    %
    
    $
    19,437
    
    
    
    3.42
    %CMO collateral
    
    
    342
    
    
    
    3.26
    
    
    
    2,506
    
    
    
    6.69Total interest income
    
    
    28,523
    
    
    
    
    
    
    
    21,943Interest expense:Repurchase arrangements and similar
borrowings
    
    
    19,739
    
    
    
    2.52
    
    
    
    5,830
    
    
    
    1.11CMO borrowings
    
    
    244
    
    
    
    2.33
    
    
    
    2,293
    
    
    
    6.12Total interest expense
    
    
    19,983
    
    
    
    
    
    
    
    8,123$
    8,540
    
    
    
    
    
    
    $
    13,820
 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, 2005Rate*
    
    
    Volume*
    
    
    TotalInterest income:Mortgage securities and other investments
    
    $
    (523
    )
    
    $
    9,267
    
    
    $
    8,744CMO collateral
    
    
    (900
    )
    
    
    (1,264
    )
    
    
    (2,164
    )Total interest income
    
    
    (1,423
    )
    
    
    8,003
    
    
    
    6,580Interest expense:Repurchase arrangements and similar
borrowings
    
    
    10,109
    
    
    
    3,800
    
    
    
    13,909CMO borrowings
    
    
    (948
    )
    
    
    (1,101
    )
    
    
    (2,049
    )Total interest expense
    
    
    9,161
    
    
    
    2,699
    
    
    
    11,860$
    (10,584
    )
    
    $
    5,304
    
    
    $
    (5,280
    )
   *
    
    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 and guaranteed by
government-sponsored entities, either Fannie Mae or Freddie Mac, or by an agency of the federal
government, Ginnie Mae (collectively, Agency Securities). Capstead has also made limited
investments in credit-sensitive commercial real estate-related assets, including the direct
ownership of real estate. Management believes such investments, when available at favorable prices
and combined with the prudent use of leverage, can produce attractive risk-adjusted returns over
the long term with relatively low sensitivity to changes in interest rates. The size and composition of Capsteads investment portfolios depend on investment strategies being
implemented by management, the availability of attractively-priced investments and overall market
conditions. Market conditions are influenced by, among other things, current levels of, and
expectations for future levels of, 30-day to two-year interest rates and mortgage prepayments.
After having increased the size of the mortgage securities and similar investments portfolio to
nearly $3.4 billion during 2004 from $2.2 billion at the previous year-end, during the first
quarter of 2005 the Company acquired sufficient ARM securities to replace portfolio runoff and
maintain the portfolio at the $3.4 billion level. The Company intends to continue pursuing the
acquisition of attractively-priced ARM securities, while also investigating other real
estate-related opportunities. Beginning on June 30, 2004, in response to growth expectations for the United States economy, the
Federal Reserves Federal Open Market Committee (the Federal Reserve) has acted to increase
short-term interest rates a total of 175 basis points by raising the federal funds rate 25 basis
points at each of its last seven meetings and is expected to further increase rates at future
meetings. Higher short-term interest rates are increasing the Companys borrowing costs, thereby
reducing financing spreads (the difference between yields earned on the Companys mortgage
investments and interest rates charged on related borrowings). The effects of rising borrowing
costs on financing spreads can eventually be mitigated by ARM security yield increases which are
expected to continue resetting higher throughout 2005. However, current market expectations call
for the Federal Reserve to continue increasing the federal funds rate 25 basis points at each of
its next four scheduled meetings through the end of the third quarter of 2005 for a total of 150
basis points this year, which will further increase the Companys borrowing rates. In this
environment, it is anticipated that portfolio yield increases will not keep pace with rising
borrowing rates. As a result, quarterly operating income and dividends will likely continue
declining modestly. Once the Federal Reserve slows its pace of raising rates, it is anticipated
that ongoing ARM security yield increases will again allow for earnings improvements. Of course,
if the Federal Reserve increases the federal funds rate more than 150 basis points in 2005, or in
increments greater than 25 basis points at any one of its meetings, the pressure on the Companys
earnings would be more pronounced and an earnings recovery would be further delayed. Risk Factors and Critical Accounting Policies Under the captions Effects of Interest Changes, Risks Associated with Credit-Sensitive
Investments, Risks Associated with Owning Real Estate, Regulatory Matters and Critical
Accounting Policies are discussions of risk factors and critical accounting policies affecting
Capsteads financial condition and -15-




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##### Table of Contents



results of operations that are an integral part of this discussion and analysis. Readers are
strongly urged to consider the potential impact of these factors and accounting policies on the
Company while reading this document. Book Value per Common Share As of March 31, 2005, Capsteads book value per common share was $7.59, a decrease of $0.32 from
December 31, 2004. This decrease was caused by declines in the aggregate unrealized gain on the
Companys mortgage investments as a result of the higher interest rate environment and portfolio
runoff, and dividend payments in excess of net income. The Company did not sell common shares into
the open market during the first quarter of 2005 as it did throughout 2004. Consequently, capital
stock transactions had no effect on the change in book value this quarter. The decline in the
aggregate unrealized gain on the Companys mortgage investments (most of which are debt securities
carried at fair value with changes in fair value reflected in stockholders equity) and other
elements of accumulated other comprehensive income lowered book value by $0.27 per share. Dividend
payments in excess of net income, which occur primarily because the Company currently distributes
all cash flow from its net-leased real estate, lowered book value by $0.05 per share. The unrealized gain on the Companys mortgage investments can be expected to fluctuate with changes
in portfolio size and composition, as well as changes in interest rates and market liquidity. Such
changes will largely be reflected in book value per common share. Book value will also be affected
by other factors, including capital stock transactions and the level of dividend distributions
relative to quarterly net income; however, temporary changes in fair values of investments not
carried at fair value on the Companys balance sheet generally will not affect book value. Mortgage Securities and Similar Investments As of March 31, 2005, the mortgage securities and similar investments portfolio consisted primarily
of ARM Agency Securities. ARM securities held by the Company are backed by mortgage loans that
have interest rates that adjust at least annually to more current interest rates (current-reset
ARM securities) or begin doing so after an initial fixed-rate period (longer-to-reset ARM
securities). Agency Securities are AAA-rated and are 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, 2005 are adjustable-rate mezzanine classes and therefore carry credit risk associated
with the underlying pools of commercial mortgage loans that is mitigated by subordinate bonds held
by other investors. Mortgage securities held by Capstead are financed under repurchase
arrangements with investment banking firms pursuant to which specific securities are pledged as
collateral. Should the Company acquire financial assets that are not mortgage-backed securities,
similar financing arrangements with other parties, such as commercial banks, may be employed (see
Liquidity and Capital Resources). During the first quarter of 2005, the Company maintained the mortgage securities and similar
investments portfolio at approximately $3.4 billion by acquiring ARM securities totaling $297
million which offset $264 million in portfolio runoff. Annualized portfolio runoff rates moderated
somewhat to 27% during the first quarter from 29% during the fourth quarter of 2004 but are
expected to be higher in the coming quarters, in part due to the portfolio consisting of more newly
issued and therefore less seasoned ARM securities than in the past. The Company anticipates that
it will continue to pursue acquisitions of ARM securities to replace portfolio runoff during 2005;
however, there can be no assurance that attractively-priced ARM securities will continue to be
available. To the extent the proceeds of mortgage prepayments and other maturities are not
reinvested or cannot be reinvested at a rate of return on invested capital at -16-




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##### Table of Contents



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 2005
for components of the mortgage securities and similar investments portfolio and anticipated second
quarter 2005 asset yields and borrowing rates based on interest rates in effect on April 21, 2005
(the date first quarter 2005 results were released) (dollars in thousands): 1st
Quarter Average(a)
    
    
    As of March 31, 2005
    
    
    Projected
    
    
    LifetimeActual
    
    
    Actual
    
    
    Premiums
    
    
    
    
    
    
    2nd Quarter
    
    
    RunoffBasis
    
    
    Yield/Cost
    
    
    Runoff
    
    
    (Discounts)
    
    
    Basis(a)
    
    

Yield/Cost(b)
    
    
    AssumptionsAgency Securities:Fannie Mae/Freddie
Mac:Fixed-rate
    
    $
    33,336
    
    
    
    6.09
    %
    
    
    44
    %
    
    $
    126
    
    
    $
    30,828
    
    
    
    6.36
    %
    
    
    39
    %ARMs
    
    
    2,181,718
    
    
    
    3.32
    
    
    
    27
    
    
    
    40,628
    
    
    
    2,206,090
    
    
    
    3.59
    
    
    
    32Ginnie Mae ARMs
    
    
    1,025,911
    
    
    
    3.15
    
    
    
    27
    
    
    
    6,949
    
    
    
    1,021,892
    
    
    
    3.40
    
    
    
    293,240,965
    
    
    
    3.29
    
    
    
    28
    
    
    
    47,703
    
    
    
    3,258,810
    
    
    
    3.56
    
    
    
    31Non-agency Securities:Fixed-rate
    
    
    32,063
    
    
    
    6.15
    
    
    
    44
    
    
    
    11
    
    
    
    29,646
    
    
    
    6.40
    
    
    
    38ARMs
    
    
    53,995
    
    
    
    3.87
    
    
    
    26
    
    
    
    548
    
    
    
    52,206
    
    
    
    4.30
    
    
    
    3786,058
    
    
    
    4.72
    
    
    
    33
    
    
    
    559
    
    
    
    81,852
    
    
    
    50.9
    
    
    
    37CMBS  adjustable-rate
    
    
    51,077
    
    
    
    3.61
    
    
    
    1
    
    
    
    9
    
    
    
    51,007
    
    
    
    4.18
    
    
    
    13,378,100
    
    
    
    3.33
    
    
    
    27
    
    
    $
    48,271
    
    
    
    3,391,669
    
    
    
    3.60
    
    
    
    31Borrowings:30-day LIBOR
    
    
    2,433,406
    
    
    
    2.53
    
    
    
    
    
    
    
    
    
    
    
    2,456,170
    
    
    
    2.99>30-day LIBOR
    
    
    705,499
    
    
    
    2.46
    
    
    
    
    
    
    
    
    
    
    
    676,727
    
    
    
    2.513,138,905
    
    
    
    2.52
    
    
    
    
    
    
    
    
    
    
    
    3,132,897
    
    
    
    2.89Capital employed/
financing spread
    
    $
    239,195
    
    
    
    0.81
    
    
    
    
    
    
    
    
    
    
    $
    258,772
    
    
    
    0.71Return on assets (c)
    
    
    
    
    
    
    1.00
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    0.89
   (a)
    
    Basis represents Capstead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 2005 reflect ARM coupon resets and
lifetime runoff assumptions as adjusted for expected runoff for this quarter only, as of
April 21, 2005. Actual yields realized in future periods will largely depend upon (i)
changes in portfolio composition, (ii) ARM coupon resets, (iii) actual runoff and (iv) any
changes in lifetime runoff assumptions. Projected interest rates on borrowings that reset
every 30 days at the 30-day London Interbank Offered Rate (LIBOR) reflect the 25 basis
point increase in the federal funds rate on March 22, 2005 and expectations for additional 25
basis point increases at the May 3 and June 30, 2005 Federal Reserve meetings.(c)
    
    The Company uses its liquidity to pay down borrowings. Return on assets is calculated on an
annualized basis assuming the use of this liquidity to reduce borrowing costs (see
Utilization of Capital and Potential Liquidity). Financing spreads declined 27 basis points during the first quarter of 2005 to 0.81%, as
higher mortgage investment yields were more than offset by increases in borrowing rates. The
overall yield earned on the portfolio averaged 3.33% during the first quarter, a 17 basis point
improvement over the prior quarter. Yields on current-reset ARM securities fluctuate as coupon
interest rates on underlying mortgage loans reset periodically to a margin over a current
short-term interest rate index (typically, a one-year index), generally subject to periodic and
lifetime limits or caps. Coupon interest rate resets are expected to continue trending higher in
the aggregate, contributing to improving portfolio yields in the coming quarters. For example,
based on interest rate expectations as of April 21, 2005, portfolio yields are expected to improve
27 basis points to approximately 3.60% for the second quarter of 2005. By the first quarter of
2006, the average yield on the existing portfolio will likely exceed 4.40%. Yields are also
affected by mortgage prepayments, which impact how quickly purchase premiums are amortized to -17-




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##### Table of Contents



earnings. Actual yields will depend on portfolio composition as well as fluctuations in, and
market expectations for fluctuations in, interest rates and mortgage prepayments. Average rates on borrowings secured by mortgage investments increased 44 basis points to 2.52%
during the first quarter of 2005 over the prior quarter and are expected to increase further in the
coming quarters. The Federal Reserve has acted to increase short-term interest rates a total of
175 basis points since June 30, 2004 by raising the federal funds rate 25 basis points at each of
its last seven meetings and is expected to continue to increase rates in response to current growth
expectations for the United States economy. The Company has extended maturities for up to two
years on a portion of its borrowings in order to effectively lock in attractive financing spreads
on the Companys modest position in fixed-rate securities and longer-to-reset ARM securities over
the average expected fixed-rate terms of these investments. Interest rates on the rest of the
Companys short-term borrowings remain largely dependent on actions by the Federal Reserve to
change short-term interest rates, market expectations of future changes in short-term interest
rates and the extent of changes in financial market liquidity. CMO Collateral and Investments Since exiting the residential mortgage loan conduit business in 1995, Capstead has maintained
finance subsidiaries with capacity to issue CMOs and other securitizations backed by residential
mortgage loans. The last CMO issued by the Company was in 2000 and the Company does not currently
anticipate issuing additional CMOs. In prior years, the Company periodically exercised its right
to redeem previously issued CMOs (referred to as Clean-up Calls) selling some of the released
collateral and holding the rest for investment as part of the Non-agency Securities portfolio. As
of March 31, 2005, the Company held Clean-up Call rights on only one of its four remaining CMOs.
Consequently, additional gains from CMO redemptions are not anticipated. CMO collateral net of
related bonds totaled $358,000 at March 31, 2005, compared to $452,000 at December 31, 2004.
Without the issuance of CMOs in which the Company retains residual interests, this portfolio is not
expected to contribute significantly to operating results in future periods. Real Estate Held For Lease In May 2002 Capstead acquired six independent senior living properties wherein the operator of
the facility provides tenants little, if any, medical care (the Properties). Concurrent with the
acquisition of the Properties, the Company entered into a long-term net-lease arrangement (the
Lease) with Brookdale Living Communities, Inc., (Brookdale), under which Brookdale is
responsible for the ongoing operation and management of the Properties. Brookdale, an owner,
operator, developer and manager of senior living facilities, is a majority-owned affiliate of
Fortress Investment Group LLC, a former affiliate. Real estate held for lease and related assets,
net of accumulated depreciation, related borrowings and other related liabilities, totaled $20.3
million at March 31, 2005 compared to $20.9 million at December 31, 2004. The following table
summarizes information about the Properties: Property
    
    Location
    

Units(a)
    

Occupancy(b)
    

Year
OpenedChambrel at Roswell
    
    Roswell, GA
    
    280 (256 IL; 24 AL
    )
    
    98.6
    %
    
    
    1987Chambrel at Pinecastle
    
    Ocala, FL
    
    161 (120 IL; 41 AL
    )
    
    100.0
    
    
    
    1987Chambrel at Island Lake
    
    Longwood, FL
    
    269 (229 IL; 40 AL
    )
    
    95.9
    
    
    
    1985Chambrel at Montrose
    
    Akron, OH
    
    169 (137 IL; 32 AL
    )
    
    95.9
    
    
    
    1987Chambrel at Williamsburg
    
    Williamsburg, VA
    
    255 (200 IL; 55 AL
    )
    
    99.2
    
    
    
    1987Chambrel at Club Hill
    
    Garland, TX
    
    260 (192 IL; 68 AL
    )
    
    90.4
    
    
    
    1987Total
    
    
    
    1,394 (1,134 IL; 260 AL
    )
    
    96.5
   (a)
    
    IL refers to independent living units. AL refers to assisted living units.(b)
    
    As of March 31, 2005. -18-




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##### Table of Contents



The Lease has an initial term of 20 years and provides for two 10-year renewal periods.
Beginning in May 2007, Brookdale will have the option of purchasing all of the Properties from
Capstead at the greater of fair value or Capsteads original cost, after certain adjustments.
Under the terms of the Lease, Brookdale is responsible for paying all expenses associated with
operating the Properties, including real estate taxes, other government charges, insurance,
utilities and maintenance, and an amount representing an attractive cash return on Capsteads
equity in the Properties after payment of monthly debt service. In keeping with Capsteads
strategy of investing in assets that can produce attractive returns over the long term with less
sensitivity to changes in interest rates, changes in monthly debt service requirements are the
responsibility of Brookdale under the terms of the Lease. Utilization of Capital and Potential Liquidity The following table illustrates Capsteads utilization of capital and potential liquidity as of
March 31, 2005 in comparison with December 31, 2004 (in thousands): Capital
    
    
    PotentialAssets
    
    
    Borrowings
    
    
    Employed
    
    

Liquidity(a)Mortgage securities and similar
investments:Agency Securities
    
    $
    3,277,026
    
    
    $
    3,020,509
    
    
    $
    256,517
    
    
    $
    156,868Non-agency Securities
    
    
    82,326
    
    
    
    64,174
    
    
    
    18,152
    
    
    
    12,907CMBS
    
    
    51,039
    
    
    
    48,214
    
    
    
    2,825
    
    
    
    (85
    )3,410,391
    
    
    
    3,132,897
    
    
    
    277,494
    
    
    
    169,690CMO collateral
    
    
    29,244
    
    
    
    28,886
    
    
    
    358
    
    
    
    Real estate held for lease (b)
    
    
    140,215
    
    
    
    119,941
    
    
    
    20,274
    
    
    
    $
    3,579,850
    
    
    $
    3,281,724
    
    
    
    298,126
    
    
    
    169,690Other assets, net of other liabilities
    
    
    
    
    
    
    
    
    
    
    31,848
    
    
    
    4,079
    (c)First quarter common dividend
    
    
    
    
    
    
    
    
    
    
    (3,397
    )
    
    
    (3,397
    )(d)Targeted liquidity reserves for funding
principal payments and margin calls
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (164,966
    )$
    326,577
    
    
    $
    5,406Balances as of December 31, 2004
    
    $
    3,579,480
    
    
    $
    3,341,795
    
    
    $
    332,539
    
    
    $
    9,783
   (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 the indicated dates,
adjusted separately for targeted liquidity reserves.(b)
    
    Real estate held for lease includes related assets and is net of accumulated depreciation
and other related liabilities.(c)
    
    Represents unrestricted cash and cash equivalents.(d)
    
    The first quarter 2005 common dividend was declared March 17, 2005 and paid April 21, 2005
to stockholders of record as of March 31, 2005. 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. The
Company establishes targeted liquidity reserves reflecting managements determination 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. CMO collateral is pledged to secure CMO bonds. Real estate held for lease and related assets are
pledged to secure long-term borrowings. Although Capstead has no responsibility for CMO bonds or
borrowings secured by real estate beyond these assets, the Companys equity in these investments
cannot presently be -19-




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##### Table of Contents



pledged to secure additional borrowings on a daily basis similar to how the Company finances its
mortgage securities using repurchase arrangements. Therefore, any additional borrowings that could
be secured by this equity are not included in potential liquidity at this time. Potential
liquidity is affected by, among other things, changes in market value of assets pledged under
borrowing arrangements, principal prepayments and general conditions in the investment banking,
mortgage finance and real estate industries. Future levels of financial leverage will be dependent
upon many factors, including the size and composition of the Companys investment portfolios (see
Liquidity and Capital Resources). -20-




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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 312005
    
    
    2004Mortgage securities and similar investments:Agency Securities
    
    $
    7,749
    
    
    $
    11,673Non-agency Securities
    
    
    521
    
    
    
    1,701CMBS
    
    
    136
    
    
    
    182CMO collateral
    
    
    84
    
    
    
    217Net margin on financial assets
    
    
    8,490
    
    
    
    13,773Real estate held for lease:Lease revenue net of related interest expense
    
    
    1,373
    
    
    
    1,440Real estate depreciation
    
    
    (927
    )
    
    
    (927
    )Net margin on real estate held for lease
    
    
    446
    
    
    
    513Other revenue (expense):CMO administration and other
    
    
    196
    
    
    
    67Other operating expense
    
    
    (1,530
    )
    
    
    (1,999
    )Total other revenue (expense)
    
    
    (1,334
    )
    
    
    (1,932
    )Net income
    
    
    7,602
    
    
    
    12,354Less cash dividends paid on preferred stock
    
    
    (5,064
    )
    
    
    (5,067
    )Net income available to common stockholders
    
    $
    2,538
    
    
    $
    7,287Operating income *
    
    $
    3,465
    
    
    $
    8,298Weighted average shares outstanding:Basic
    
    
    18,860
    
    
    
    14,267Diluted
    
    
    18,885
    
    
    
    14,620Operating *
    
    
    18,885
    
    
    
    14,620Net income per common share:Basic
    
    $
    0.13
    
    
    $
    0.51Diluted
    
    
    0.13
    
    
    
    0.50Operating *
    
    
    0.18
    
    
    
    0.57Regular common dividends declared per share
    
    $
    0.18
    
    
    $
    0.53
   *
    
    Capstead reports operating income per common share (a non-GAAP financial
measure calculated excluding depreciation on real estate, any gain on asset sales
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 $2.15 (the Series B preferred share annualized
dividend of $1.26 divided by the current conversion rate of 0.5867). Operating
income per common share excludes the dilutive effects, if present, of the Series B
preferred shares because it is not economically advantageous to convert these shares
at market prices of both the common shares and Series B preferred shares; therefore
few, if any, Series B preferred share conversions are expected. -21-




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Net margins on financial assets and related financing spreads benefited significantly in prior
years from actions taken by the Federal Reserve beginning in 2001 to lower short-term interest
rates, which resulted in significantly lower interest rates on the Companys borrowings even as
lower interest rates also led to steadily declining yields on the Companys adjustable-rate assets
and relatively high mortgage prepayment rates. This trend of declining asset yields reversed
during the fourth quarter of 2004 leading to two consecutive quarter-over-quarter increases in
overall portfolio yields for the first time in over four years. Given current expectations for
interest rates, portfolio yields are expected to continue trending higher in the coming quarters. Short-term interest rates began increasing in June 2004 in response to Federal Reserve actions to
raise the federal funds rate. These higher rates resulted in significantly higher borrowing rates
contributing to declining net margins and financing spreads for the Company. This illustrates how
the Company is impacted immediately when short-term interest rates rise (and fall) while ARM
security yields change slowly in comparison because coupon interest rates on the underlying
mortgage loans generally reset only once a year and the amount of each reset can be limited or
capped. Because the majority of Capsteads financial asset portfolios currently consist of ARM securities,
management believes Capstead is well positioned to manage through the anticipated higher interest
rate environment, albeit at reduced financing spreads and, therefore, at a reduced earnings level
than that achieved the last several years when short-term interest rates were declining. See
Financial Condition  Overview and Mortgage Securities and Similar Investments for further
discussion of the current operating environment. Key operating statistics for each component of the mortgage securities and similar investments
portfolio were as follows for the indicated periods (dollars in millions): Quarter Ended March 312005
    
    
    2004Agency Securities:Portfolio
    
    $
    3,241
    
    
    $
    2,007Yields
    
    
    3.29
    %
    
    
    3.33
    %Borrowing rates
    
    
    2.50
    
    
    
    1.07Financing spreads
    
    
    0.79
    
    
    
    2.26Portfolio runoff rates (annualized)
    
    
    27.61
    
    
    
    21.65Non-agency Securities:Portfolio
    
    $
    86
    
    
    $
    188Yields
    
    
    4.72
    %
    
    
    4.88
    %Borrowing rates
    
    
    2.91
    
    
    
    1.52Financing spreads
    
    
    1.81
    
    
    
    3.36Portfolio runoff rates (annualized)
    
    
    33.47
    
    
    
    45.25CMBS:Portfolio
    
    $
    51
    
    
    $
    73Yields
    
    
    3.61
    %
    
    
    2.19
    %Borrowing rates
    
    
    2.70
    
    
    
    1.29Financing spreads
    
    
    0.91
    
    
    
    0.90Portfolio runoff rates (annualized)
    
    
    1.25
    
    
    
    5.80
 The Agency Securities portfolio continues to be the primary contributor to Capsteads operating
results. However, the impact of lower financing spreads was evident in current quarter results,
which were less than in the same period in 2004 despite a higher average portfolio outstanding.
Non-agency Securities -22-




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##### Table of Contents



contributed less to operating results during the current quarter primarily because of a lower
average portfolio outstanding but results were also negatively affected by lower financing spreads.
This portfolio declined with runoff and the March 2004 securitization and transfer of $53 million
of high coupon fixed-rate Non-agency Securities into Fannie Mae Agency Securities. Unlike
residential ARM securities, Capsteads CMBS holdings adjust monthly to changes in 30-day LIBOR.
Consequently, financing spreads have held steady. However, results from this portfolio have been
impacted by declining portfolio balances. Real estate held for lease contributed less to operating results during the current quarter
primarily because late in 2004 Capstead was released from a $6 million line of credit requirement
that the properties tenant was paying Capstead $79,000 a quarter to provide. This decline was
partially offset by a May 1, 2004 scheduled rent increase. CMO collateral balances have declined significantly the last several years primarily because of
high mortgage prepayments and the exercise of Clean-up Calls. With continued runoff of this
portfolio, related contributions to operating results are expected to continue declining. With
declining CMO and Non-agency Securities portfolio balances for which the Company provides
administrative services, CMO administration revenue also is continuing to trend lower. Other
revenue was higher during the first quarter of 2005 compared to the same period in 2004 due
primarily to higher overnight investment earnings and a $65,000 recovery on a 1997 loan loss. Other operating expense was lower in the current quarter compared to the same period in 2004
primarily because of lower current year accruals for incentive fees reflecting expectations for
lower 2005 earnings and dividends and the effects on book value of declines in unrealized gains on
mortgage securities. LIQUIDITY AND CAPITAL RESOURCES Capsteads primary sources of funds are borrowings under repurchase arrangements and monthly
principal and interest payments on mortgage securities and similar investments. Other sources of
funds include proceeds from other borrowing arrangements, proceeds from asset sales, unrestricted
payments received on real estate held for lease and proceeds from equity offerings. The Company
generally uses its liquidity to pay down borrowings under repurchase arrangements to reduce
borrowing costs and otherwise efficiently manage its capital. Because the level of these
borrowings can be adjusted on a daily basis, the level of unrestricted cash and cash equivalents
carried on the balance sheet is less important than the Companys potential liquidity available
under its borrowing arrangements. The table included under Financial Condition  Utilization of
Capital and Potential Liquidity and accompanying discussion illustrates additional funds
potentially available to the Company as of March 31, 2005, as adjusted for targeted liquidity
reserves. The Company currently believes that it has ample liquidity and capital resources
available for the acquisition of additional investments, repayments on borrowings and the payment
of cash dividends as required for Capsteads continued qualification as a REIT. It is the
Companys policy to remain strongly capitalized and conservatively leveraged. Borrowings under repurchase arrangements secured by mortgage securities totaled $3.1 billion at
March 31, 2005. Most of these borrowings have maturities of less than 31 days, although from time
to time the Company may enter into longer-term arrangements as it has done on a portion of its
borrowings totaling $677 million as of quarter end (see discussion above under Mortgage Securities
and Similar Investments). Capstead has uncommitted repurchase facilities with investment banking
firms to finance these investments, subject to certain conditions. Interest rates on these
borrowings are generally 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. -23-




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##### Table of Contents



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. CMO borrowings totaled $29 million at March 31, 2005 and are secured by CMO collateral pledged to
the related indentures. As such, recourse is limited to this collateral and therefore has a
limited impact on Capsteads liquidity and capital resources. Mortgage prepayments and Clean-up
Calls affect the maturity of each CMO series. With its acquisition of senior living properties in May 2002, Capstead assumed $19 million in
fixed-rate mortgage financing from a commercial bank that matures in 2009 and $101 million in
tax-exempt bond debt. In November 2002, the tax-exempt bonds were refunded with proceeds from
issuing new 30-year adjustable-rate tax-exempt bonds. Under the terms of the Lease, changes in
interest rates on this debt are the responsibility of the lessee and as such, have a limited effect
on the Companys liquidity. After having raised over $64 million of new common equity during 2004 through limited open market
sales, no such sales occurred during the first quarter of 2005 but may resume later in 2005 if
market conditions allow. EFFECTS OF INTEREST RATE CHANGES Interest Rate Sensitivity on Operating Results Capstead performs earnings sensitivity analysis using an income simulation model to estimate the
effects that specific interest rate changes can reasonably be expected to have on future earnings.
All financial assets and derivative financial instruments (Derivatives) held are included in this
analysis. The sensitivity of components of Other revenue (expense)to changes in interest rates is
included as well, although no asset sales are assumed. Because under the terms of the Lease the
lessee is responsible for changes in related debt service requirements, earnings from the Companys
investment in net-leased real estate are generally not affected by changes in interest rates. The
model incorporates management assumptions regarding the level of mortgage prepayments for a given
interest rate change using market-based estimates of prepayment speeds for purposes of amortizing
investment premiums and discounts. These assumptions are developed through a combination of
historical analysis and future expected pricing behavior. Capstead had the following estimated
earnings sensitivity profile as of March 31, 2005 and December 31, 2004, 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, 2005
    
    
    2.87
    %
    
    
    4.45
    %
    
    $
    (2,247
    )
    
    $
    (15,851
    )
    
    $
    (14,988
    )
    
    $
    (34,077
    )December 31, 2004
    
    
    2.40
    
    
    
    4.22
    
    
    
    (2,297
    )
    
    
    (12,760
    )
    
    
    (11,793
    )
    
    
    (29,259
    )
   *
    
    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. -24-




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Income simulation modeling is the primary tool used by management to assess the direction and
magnitude of changes in net margins on financial assets resulting from changes in interest rates.
Key assumptions in the model include mortgage prepayment rates, changes in market conditions and
managements financial capital plans. These assumptions are inherently uncertain and, as a result,
the model cannot precisely estimate net margins or precisely predict the impact of higher or lower
interest rates on net margins. Actual results will differ from simulated results due to timing,
magnitude and frequency of interest rate changes and other changes in market conditions, management
strategies and other factors. General Discussion of Effects of Interest Rate Changes Changes in interest rates may affect Capsteads earnings in various ways. Earnings currently
depend, in large part, on the difference between the interest received on mortgage securities and
similar investments, and the interest paid on related borrowings, most of which are 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
currently consists primarily of current-reset ARM securities, the effects of rising short-term
interest rates on borrowing costs can eventually be mitigated by increases in the rates of interest
earned on the underlying ARM loans, which generally reset periodically to a margin over a current
short-term interest rate index (typically a one-year index) subject to periodic and lifetime
limits, referred to as caps. Additionally, the Company has extended maturities on a portion of its
borrowings, which has effectively locked in attractive financing spreads on the Companys modest
position in fixed-rate and longer-to-reset ARM securities over the average expected fixed-rate
terms of these investments. As of March 31, 2005 the Companys ARM securities featured the
following average coupon rates, and average periodic and lifetime caps (dollars in thousands): Average
    
    
    Average
    
    
    Average
    
    
    MonthsCoupon
    
    
    Periodic
    
    
    Lifetime
    
    
    ToARM Type
    
    Basis *
    
    
    Rate
    
    
    Cap
    
    
    Cap
    
    
    RollAgency
Securities:Fannie Mae/Freddie
Mac:Current-reset
    
    $
    1,689,491
    
    
    
    3.98
    %
    
    
    2.08
    %
    
    
    10.83
    %
    
    
    6.0Longer-to-reset
    
    
    516,600
    
    
    
    4.65
    
    
    
    4.48
    
    
    
    10.62
    
    
    
    25.7Ginnie Mae
    
    
    1,021,892
    
    
    
    3.84
    
    
    
    1.00
    
    
    
    9.94
    
    
    
    5.6Non-agency Securities
    
    
    52,206
    
    
    
    4.39
    
    
    
    1.72
    
    
    
    11.24
    
    
    
    5.9$
    3,280,189
    
    
    
    4.05
    
    
    
    2.12
    
    
    
    10.53
    
    
    
    9.0
   *
    
    Basis represents the Companys investment before unrealized gains and losses. Since only a portion of the ARM loans underlying these securities reset each month subject to
periodic and lifetime caps, interest rates on related borrowings can rise to levels that may exceed
the interest rates on the underlying loans, contributing to lower or even negative financing
spreads. At other times, declines in these indices during periods of relatively low short-term
interest rates will negatively effect yields on ARM securities as the underlying ARM loans reset at
lower rates. If declines in these indices exceed declines in the Companys borrowing rates,
earnings would be adversely affected. To provide some protection to financing spreads against
rising interest rates, the Company may from time to time enter into longer-term repurchase
arrangements on a portion of its borrowings (as it has done currently on borrowings related to its
fixed-rate and longer-to-reset ARM securities) or invest in Derivatives such as interest rate swap
or cap agreements. At March 31, 2005, the Company did not own any Derivatives for this purpose. -25-




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Another effect of changes in interest rates is that as long-term interest rates decrease, the rate
of principal prepayments on mortgage loans underlying mortgage securities and similar investments
generally increases. During periods of relatively low interest rates, prolonged periods of high
prepayments can significantly reduce the expected life of these investments; therefore, the actual
yields realized can be lower due to faster amortization of premiums. Further, to the extent the
proceeds of prepayments are not reinvested or cannot be reinvested at a rate of interest at least
equal to the rate previously earned on that capital, earnings may be adversely affected. There can
be no assurance that suitable investments at attractive pricing will be available on a timely basis
to replace runoff as it occurs or that the current composition of investments (consisting primarily
of ARM Agency Securities) will be maintained. Capstead periodically sells assets, which may increase income volatility because of the recognition
of transactional gains or losses. Such sales may become attractive as asset values fluctuate with
changes in interest rates. At other times, asset sales may become prudent to shift the Companys
investment focus. During periods of rising interest rates or contracting market liquidity, asset
values can decline, leading to increased margin calls and reducing the Companys liquidity. A
margin call means that a lender requires a borrower to pledge additional collateral to re-establish
the agreed-upon ratio of the value of the collateral to the amount of the borrowing. If the
Company is unable or unwilling to pledge additional collateral, lenders can liquidate the
collateral under adverse market conditions, likely resulting in losses. RISKS ASSOCIATED WITH CREDIT-SENSITIVE INVESTMENTS Commercial mortgage assets may be viewed as exposing an investor to greater risk of loss than
residential mortgage assets since such assets are typically secured by larger loans to fewer
obligors than residential mortgage assets. Commercial property values and related net operating
income are often subject to volatility, and net operating income may be sufficient or insufficient
to cover debt service on the related mortgage loan at any given time. The repayment of loans
secured by income-producing properties is typically dependent upon the successful operation of the
related real estate project and the ability of the applicable property to produce net operating
income rather than upon the liquidation value of the underlying real estate. Even when the current
net operating income is sufficient to cover debt service, there can be no assurance that this will
continue to be the case in the future. Additionally, commercial properties may not be readily convertible to alternative uses if such
properties were to become unprofitable due to competition, age of improvements, decreased demand,
regulatory changes or other factors. The conversion of commercial properties to alternate uses
often requires substantial capital expenditures, which may or may not be available. The availability of credit for commercial mortgage loans may be dependent upon economic conditions
in the markets where such properties are located, as well as the willingness and ability of lenders
to make such loans. The availability of funds in the credit markets fluctuates and there can be no
assurance that the availability of such funds will increase above, or will not contract below,
current levels. In addition, the availability of similar commercial properties, and the
competition for available credit, may affect the ability of potential purchasers to obtain
financing for the acquisition of properties. This could affect the repayment of commercial
mortgages. Credit-sensitive residential mortgage assets differ from commercial mortgage assets in several
important ways yet can still carry substantial credit risk. Residential mortgage securities
typically are secured by smaller loans to more obligors than CMBS, thus spreading the risk of
mortgagor default. However, most of the mortgages supporting credit-sensitive residential
securities are made to homeowners that do not qualify for Agency loan programs for reasons
including loan size, financial condition, or work or credit history that may be indicative of
higher risk of default than loans qualifying for such programs. As with commercial mortgages, in
instances of default the Company may incur losses if proceeds from sales of -26-




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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. Similarly, junior liens and other forms of subordinated financing on single commercial properties
carry greater credit risk than senior lien financing, including a substantially greater risk of
non-payment of interest or principal. A decline in the value of the underlying real estate could
be large enough such that the aggregate outstanding balances of senior liens could exceed the value
of the real estate. In the event of default on a senior loan, the junior lienholder may need to
make payments on the senior loans in order to prevent foreclosure. Because the senior lienholders
generally have priority on proceeds from liquidating the underlying real estate, junior lienholders
may not recover all or any of their investment. To compensate for this heightened credit risk,
these loans generally earn substantially higher yields. The availability of capital from external sources to finance investments in credit-sensitive
commercial and residential mortgage assets may be diminished during periods of mortgage finance
market illiquidity. Additionally, if market conditions deteriorate resulting in substantial
declines in value of these assets, sufficient capital may not be available to support the continued
ownership of such investments, requiring these assets to be sold at a loss. RISKS ASSOCIATED WITH OWNING REAL ESTATE The direct ownership of commercial real estate involves a number of risks. With its first
acquisition of real estate, Capstead has attempted to mitigate these risks by entering into a
long-term net-lease arrangement whereby the lessee is responsible for the ongoing operation and
management of the properties and for paying all expenses associated with the operation of the
properties. Although reduced by this net-lease arrangement, risks of ownership remain, including:  
    The risk that changes in economic conditions or real estate markets may adversely affect the value of the properties.  
    During inflationary periods, which are generally accompanied by rising interest rates, increases in operating costs and
borrowing rates may be greater than increases in lessee revenues from operating properties. Over an extended period of
time, this could result in lessee defaults.  
    The risk that a deterioration of local conditions could adversely affect the ability of a lessee to profitably operate
a property. For instance, an oversupply of senior living properties could hamper the leasing of senior living units at
favorable rates. This could ultimately affect the value of the properties.  
    Changes in tax, zoning or other laws could make properties less attractive or less profitable. -27-




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
    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,
damage awards to private parties and additional capital
expenditures to remedy noncompliance. Existing requirements may
change and compliance with future requirements may involve
significant unanticipated expenditures. Typically these
expenditures would be the responsibility of the lessee under the
terms of net-leases; however, if lessees fail to perform these
obligations, the owner may be required to do so.  
    Under federal, state and local environmental laws, the owner may
be required to investigate and clean up any release of hazardous
or toxic substances or petroleum products at its properties,
regardless of its knowledge or actual responsibility, simply
because of current or past ownership of the real estate. If
unidentified environmental problems arise, the owner may have to
make substantial payments, which could adversely affect cash flow
and the ability to make distributions to stockholders. This is
because:  1.
    The owner may have to pay for property damage and for investigation and clean-up
costs incurred in connection with the contamination.2.
    The law may impose clean-up responsibility and liability regardless of whether the
owner or operator knew of or caused the contamination. Even if more than one person is
responsible for the contamination, each person who shares legal liability under
environmental laws may be held responsible for all of the clean-up costs.3.
    Governmental entities and third parties may sue the owner or operator of a
contaminated site for damages and costs.  
    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. -28-




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
    An owner may desire to sell a property in the future because of
changes in market conditions or poor lessee performance or to
avail itself of other opportunities. An owner may also be
required to sell a property to meet debt obligations or avoid a
default. Unlike investments in mortgage securities, real estate
cannot always be sold quickly, and there can be no assurance that
a property can be sold at a favorable price or that a prospective
buyer will view existing lease or operating arrangements
favorably. In addition, a property may require restoration or
modification before it is sold. REGULATORY MATTERS Tax Status As used herein, Capstead REIT refers to Capstead and the entities that are consolidated with
Capstead for federal income tax purposes. Capstead REIT has elected to be taxed as a REIT for
federal income tax purposes and intends to continue to do so. As a result of this election,
Capstead REIT will not be taxed at the corporate level on taxable income distributed to
stockholders, provided that certain requirements concerning the nature and composition of its
income and assets are met and that at least 90% of its REIT taxable income is distributed. If Capstead REIT were to fail to qualify as a REIT in any taxable year, it would be subject to
federal income tax at regular corporate rates and would not receive a deduction for dividends paid
to stockholders. If this were the case, the amount of after-tax income available for distribution
to stockholders would decrease substantially. As long as Capstead REIT qualifies as a REIT, it will
generally be taxable only on its undistributed taxable income. Distributions out of current or
accumulated taxable earnings and profits will be taxed to stockholders as ordinary income or
capital gain, as the case may be, and will not qualify for the dividend tax rate reduction to 15%
enacted as part of the Jobs and Growth Tax Relief Act of 2002, except as discussed below.
Distributions in excess of Capstead REITs current or accumulated earnings and profits will
constitute a non-taxable return of capital to the stockholders (except insofar as such
distributions exceed a stockholders cost basis of the shares of stock). Distributions by the
Company will not be eligible for the dividends received deduction for corporations. Should the
Company incur losses, stockholders will not be entitled to include such losses in their individual
income tax returns. Capstead may find it advantageous from time-to-time to elect taxable REIT subsidiary status for
certain of its subsidiaries. All taxable income of Capsteads taxable REIT subsidiaries, if any, is
subject to federal and state income taxes, where applicable. Capstead REITs taxable income will
include the income of its taxable REIT subsidiaries only upon distribution of such income to
Capstead REIT, and only if these distributions are made out of current or accumulated earnings and
profits of a taxable REIT subsidiary. Should this occur, a portion of Capsteads distributions to
its stockholders could qualify for the 15% dividend tax rate provided by the Jobs and Growth Tax
Relief Act of 2002. Investment Company Act of 1940 The Investment Company Act of 1940, as amended (the Investment Company Act), exempts from
regulation as an investment company any entity that is primarily engaged in the business of
purchasing or otherwise acquiring mortgages and other liens on, and interests in, real estate.
Capstead conducts its business so as not to become regulated as an investment company. If it were
to be regulated as an investment company, Capsteads ability to use leverage would be substantially
reduced and it would be unable to conduct its business as described herein. Under the current interpretation of the staff of the Securities and Exchange Commission (SEC), in
order to be exempted from regulation as an investment company, a REIT must, among other things,
maintain at least 55% of its assets directly in qualifying real estate interests. In satisfying
this 55% requirement, a REIT may treat mortgage-backed securities issued with respect to an
underlying pool to which it holds all -29-




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issued certificates as qualifying real estate interests. If the SEC or its staff adopts a contrary
interpretation of such treatment, the REIT could be required to sell a substantial amount of these
securities or other non-qualified assets under potentially adverse market conditions. CRITICAL ACCOUNTING POLICIES Managements discussion and analysis of financial condition and results of operations is based upon
Capsteads consolidated financial statements, which have been prepared in accordance with
accounting principles generally accepted in the United States. The preparation of these financial
statements requires the use of estimates and judgments that can affect the reported amounts of
assets, liabilities (including contingencies), revenues and expenses as well as related
disclosures. These estimates are based on available internal and market information and
appropriate valuation methodologies believed to be reasonable under the circumstances, the results
of which form the basis for making judgments about the expected useful lives and carrying values of
assets and liabilities which can materially affect the determination of net income and book value
per common share. Actual results may differ from these estimates under different assumptions or
conditions. Management believes the following are critical accounting policies in the preparation of Capsteads
consolidated financial statements that involve the use of estimates requiring considerable
judgment:  
    Amortization of Premiums and Discounts on Financial Assets and
Borrowings Premiums and discounts on financial assets and
borrowings are recognized in earnings as adjustments to interest
income or interest expense by the interest method over the
estimated lives of the related assets or borrowings. For most of
Capsteads financial assets, estimates and judgments related to
future levels of mortgage prepayments are critical to this
determination. Mortgage prepayment expectations can vary
considerably from period to period based on current and projected
changes in interest rates and other factors such as portfolio
composition.  
    Fair Value and Impairment Accounting for Financial Assets Most
of Capsteads mortgage securities and similar investments are
classified as held available-for-sale and recorded at fair value
on the balance sheet with unrealized gains and losses recorded in
stockholders equity as a component of Accumulated other
comprehensive income. As such, these unrealized gains and losses
enter into the calculation of book value per common share. Fair
values fluctuate with current and projected changes in interest
rates, prepayment expectations and other factors, such as market
liquidity. Considerable judgment is required interpreting market
data to develop estimated fair values, particularly in
circumstances of deteriorating credit quality and market liquidity
(see NOTE 10 to the accompanying consolidated financial
statements for discussion of how Capstead values its financial
assets). Generally, gains or losses are recognized in earnings

only if sold; however, if a decline in fair value of an individual
asset below its amortized cost occurs that is determined to be
other than temporary, the difference between amortized cost and
fair value would be included in Other revenue (expense)as an
impairment charge.  
    Depreciation and Impairment Accounting for Real Estate held for
Lease Real estate is carried at cost, less accumulated
depreciation. Depreciation is provided using the straight-line
method over the estimated useful lives of buildings, equipment and
fixtures. If a significant adverse event or change in
circumstances occurs, management would assess if the values of the
Companys real estate properties have become impaired. If
estimated operating cash flows (undiscounted and without interest
charges) of a property over its remaining useful life are less
than its net carrying value, the difference between net carrying
value and fair value would be included in Other revenue (expense)
as an impairment charge. Considerable judgment is required in
determining useful lives of components of real estate properties
and in estimating operating cash flows, particularly during
periods of changing circumstances. -30-




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FORWARD LOOKING STATEMENTS This document contains forward-looking statements (within the meaning of the Private Securities
Litigation Reform Act of 1995) that inherently involve risks and uncertainties. Capsteads actual
results and liquidity can differ materially from those anticipated in these forward-looking
statements because of changes in the level and composition of the Companys investments and
unforeseen factors. Relative to the Companys investments in financial assets, these factors may
include, but are not limited to, changes in general economic conditions, the availability of
suitable investments from both an investment return and regulatory perspective, fluctuations in,
and market expectations for fluctuations in, interest rates and levels of mortgage prepayments,
deterioration in credit quality and ratings, the effectiveness of risk management strategies, the
impact of leverage, liquidity of secondary markets and credit markets, increases in costs and other
general competitive factors. Relative to direct investments in real estate, these factors may
include, but are not limited to, lessee performance under lease agreements, changes in general as
well as local economic conditions and real estate markets, increases in competition and
inflationary pressures, changes in the tax and regulatory environment including zoning and
environmental laws, uninsured losses or losses in excess of insurance limits and the availability
of adequate insurance coverage at reasonable costs. 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, 2005
    
    
    March 31, 2004Operating
    
    
    Diluted
    
    
    Operating
    
    
    DilutedNet income
    
    $
    7,602
    
    
    $
    7,602
    
    
    $
    12,354
    
    
    $
    12,354Adjustments for:Depreciation on real estate
    
    
    927
    
    
    
    
    
    
    
    927
    
    
    
    Series B preferred dividends
    
    
    (5,064
    )
    
    
    (5,064
    )
    
    
    (4,983
    )
    
    
    (4,983
    )$
    3,465
    
    
    $
    2,538
    
    
    $
    8,298
    
    
    $
    7,371Weighted average common shares
outstanding
    
    
    18,860
    
    
    
    18,860
    
    
    
    14,267
    
    
    
    14,267Net effect of dilutive
securities:Stock options
    
    
    25
    
    
    
    25
    
    
    
    39
    
    
    
    39Preferred A shares
    
    
    
    
    
    
    
    
    
    
    314
    
    
    
    31418,885
    
    
    
    18,885
    
    
    
    14,620
    
    
    
    14,620Per common share
    
    $
    0.18
    
    
    $
    0.13
    
    
    $
    0.57
    
    
    $
    0.50
 
 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. -31-




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ITEM 4. CONTROLS AND PROCEDURES As of March 31, 2005, an evaluation was performed under the supervision and with the participation
of the Companys management, including the Chief Executive Officer (CEO) and Chief Financial
Officer (CFO), of the effectiveness of the design and operation of the Companys disclosure
controls and procedures. Based on that evaluation, the Companys management, including the CEO and
CFO, concluded that the Companys disclosure controls and procedures were effective as of March 31,
2005. 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, 2005. 
 PART II.  OTHER INFORMATION 
 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS  (a)
    The annual meeting of stockholders was held April 21, 2005.  (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
    
    
    17,650,316
    
    
    
    
    
    
    
    418,771
    
    
    
    Gary Keiser
    
    
    17,636,806
    
    
    
    
    
    
    
    432,281
    
    
    
    Paul M. Low
    
    
    17,622,069
    
    
    
    
    
    
    
    447,018
    
    
    
    Michael G. ONeil
    
    
    17,643,028
    
    
    
    
    
    
    
    426,059
    
    
    
    Howard Rubin
    
    
    17,664,831
    
    
    
    
    
    
    
    404,256
    
    
    
    Mark S. Whiting
    
    
    17,634,847
    
    
    
    
    
    
    
    434,240
    
    
    
       Ratify Appointment of
Ernst & Young LLP as
Independent Auditors
    
    
    17,800,346
    
    
    
    158,099
    
    
    
    110,642
    
    
    
       Other matters
(no other matters)
 
 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 2002 Exhibit 31.2  Certification pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002 Exhibit 32  Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 -32-




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(b)
    Reports on Form 8-K: Current Report on Form 8-K dated January 27, 2005 announcing fourth quarter 2004 financial
results, record date for Annual Meeting of Stockholders and common dividend schedule for 2005. Current Report on Form 8-K dated March 17, 2005 declaring first quarter 2005 common dividend. Current Report on Form 8-K dated April 21, 2005 announcing first quarter 2005 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 CORPORATIONRegistrantDate: April 26, 2005
    
    
    
    By:
    
    /s/ ANDREW F. JACOBSAndrew F. JacobsPresident and Chief Executive OfficerDate: April 26, 2005
    
    
    
    By:
    
    /s/ PHILLIP A. REINSCHPhillip A. ReinschSenior Vice President and
Chief Financial Officer
 -33-