10-K 1 form10k.htm CAPSTEAD MORTGAGE CORPORATION 10-K 12-31-2015

UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549
 
FORM 10-K
 
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the fiscal year ended:         December 31, 2015
 
OR
 
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:                    001-08896
 
 
 
CAPSTEAD MORTGAGE CORPORATION
(Exact name of Registrant as specified in its Charter)
 
Maryland
 
75‑2027937
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification No.)

8401 North Central Expressway, Suite 800, Dallas, TX
 
75225-4404
(Address of principal executive offices)
 
(Zip Code)
 
Registrant’s telephone number, including area code:  (214) 874-2323
 
Securities registered pursuant to Section 12(b) of the Act:
 
Title of Each Class
 
Name of Exchange on Which Registered
     
Common Stock ($0.01 par value)
 
New York Stock Exchange
$7.50% Series E Cumulative Redeemable Preferred Stock ($0.10 par value)
 
New York Stock Exchange
 
Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  YES  NO ☐
Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  YES ☐ NO
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, and (2) has been subject to such filing requirements for the past 90 days.    YES  ☑ NO ☐
Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that Registrant was required to submit and post such files).    YES  ☑ NO ☐
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K: ☐
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.
Large accelerated filer  ☑ 
Accelerated filer ☐
Non-accelerated filer ☐
Smaller reporting company ☐
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Act). YES ☐ NO ☑
 
At June 30, 2015 the aggregate market value of the common stock held by nonaffiliates was $1,046,834,773.
 
Number of shares of Common Stock outstanding at February 26, 2016:   95,947,090
 
DOCUMENTS INCORPORATED BY REFERENCE:
Portions of the Registrant’s definitive Proxy Statement, to be issued in connection with the 2016 Annual Meeting of Stockholders of the Registrant, are incorporated by reference into Part III.
 


CAPSTEAD MORTGAGE CORPORATION
2015 FORM 10-K ANNUAL REPORT
TABLE OF CONTENTS

PART I
 
   
Page
     
ITEM 1.
2
     
ITEM 1A.
4
     
ITEM 1B.
4
     
ITEM 2.
4
     
ITEM 3.
4
     
ITEM 4.
4
PART II
     
ITEM 5.
4
     
ITEM 6.
6
     
ITEM 7.
7
     
ITEM 7A.
34
     
ITEM 8.
34
     
ITEM 9.
61
     
ITEM 9A.
61
     
ITEM 9B.
63
PART III
     
ITEM 10
63
     
ITEM 11.
63
     
ITEM 12.
63
     
ITEM 13.
63
     
ITEM 14.
63
PART IV
     
ITEM 15.
64
     
66 
 
PART I

ITEM 1. BUSINESS

Capstead Mortgage Corporation operates as a self-managed real estate investment trust for federal income tax purposes (a “REIT”) and is based in Dallas, Texas.  Unless the context otherwise indicates, Capstead Mortgage Corporation, together with its subsidiaries, is referred to as “Capstead” or the “Company.”  Capstead was incorporated in the state of Maryland in 1985 and its common and preferred stocks are listed on the New York Stock Exchange under the symbols “CMO” and “CMOPRE,” respectively.

Capstead’s investment strategy involves managing a leveraged portfolio of residential mortgage pass-through securities consisting almost exclusively of relatively short-duration adjustable-rate mortgage (“ARM”) securities issued and guaranteed by government-sponsored enterprises, either Fannie Mae or Freddie Mac, or by an agency of the federal government, Ginnie Mae.  Residential mortgage pass-through securities guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae, referred to as “Agency Securities,” are considered to have limited, if any, credit risk because of federal government support.  This strategy differentiates Capstead from its peers because ARM loans underlying its investment portfolio can reset to more current interest rates within a relatively short period of time.  This positions the Company to benefit from a potential recovery in financing spreads that typically contract during periods of rising interest rates and can result in smaller fluctuations in portfolio values compared to portfolios containing a significant amount of longer-duration ARM and fixed-rate mortgage securities.  Duration is a common measure of market price sensitivity to interest rate movements.  A shorter duration generally indicates less interest rate risk.

For further discussion of the Company’s business and financial condition, see Item 7 of this report, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” which is incorporated herein by reference.

Competition

As a residential mortgage REIT that focuses on investing in ARM Agency Securities, Capstead competes for the acquisition of suitable investments with other mortgage REITs, commercial banks, savings banks, insurance companies, and institutional investors such as private equity funds, mutual funds, pension funds and sovereign wealth funds.  Many of these entities have lower yield requirements as well as greater financial resources and access to capital than the Company.  Increased competition for the acquisition of ARM Agency Securities can result in higher pricing levels for such assets.  In addition, the availability of ARM Agency Securities for purchase in the secondary markets varies substantially with changes in market conditions and ARM origination levels, which have not kept pace with related runoff in recent years.  Although higher pricing levels generally correspond to a higher book value per common share for the Company, higher prices paid for acquisitions can adversely affect portfolio yields and future profitability.

In addition, the federal government, through the Federal Reserve as well as Fannie Mae and Freddie Mac, has accumulated substantial holdings of primarily fixed-rate Agency Securities, largely in order to provide stimulus to the economy through what has been referred to as quantitative easing programs.  These programs have had the effect of supporting higher pricing for the entire Agency Securities market, including pricing for ARM Agency Securities.  While the Federal Reserve ceased adding to its holdings of fixed-rate Agency Securities late in 2014, it continues to provide economic stimulus by replacing portfolio runoff through open market purchases.  The Federal Reserve has indicated that it intends to eventually cease replacing portfolio runoff.  This action, or a more dramatic reduction in government holdings of fixed-rate Agency Securities in the future, could result in lower pricing levels for Agency Securities, adversely affecting the Company’s book value per common share.
 
Regulation and Related Matters

Operating as a REIT investing in Agency Securities subjects Capstead to various federal tax and regulatory requirements.  For further discussion, see Item 7 of this report, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” on pages 28 through 32 under the captions “Risks Related to Capstead’s Status as a REIT and Other Tax Matters” and “Risk Factors Related to Capstead’s Corporate Structure,” which is incorporated herein by reference.

Employees

As of December 31, 2015, Capstead had 13 full-time employees and one part-time employee.

Website Access to Company Reports and Other Company Information

Capstead makes available on its website at www.capstead.com or www.capstead.reit, free of charge, its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, investor presentations and press releases, including any amendments to such documents as soon as reasonably practicable after such materials are electronically filed or furnished to the Securities and Exchange Commission (“SEC”) or otherwise publicly released.

The SEC maintains an Internet site (www.sec.gov) through which investors may view materials filed with the SEC.  Investors may also read and copy any materials filed with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, D.C. 20549.  You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330.

The Company makes available on its website charters for the committees of its board of directors, its Board of Directors’ Guidelines, its Amended and Restated Bylaws, its Code of Business Conduct and Ethics, its Financial Code of Professional Conduct and other information, including amendments to such documents and waivers, if any, to the codes.  Such information will also be furnished, free of charge, upon written request to Capstead Mortgage Corporation, Attention: Stockholder Relations, 8401 North Central Expressway, Suite 800, Dallas, Texas 75225-4404.

Cautionary Statement Concerning Forward-Looking Statements

This document contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995.  Forward-looking statements include, without limitation, any statement that may predict, forecast, indicate or imply future results, performance or achievements, and may contain the words “believe,” “anticipate,” “expect,” “estimate,” “intend,” “will be,” “will likely continue,” “will likely result,” or words or phrases of similar meaning.  Forward-looking statements are based largely on the expectations of management and are subject to a number of risks and uncertainties including, but not limited to, the following:
 
changes in general economic conditions;
fluctuations in interest rates and levels of mortgage prepayments;
the effectiveness of risk management strategies;
the impact of differing levels of leverage employed;
liquidity of secondary markets and credit markets;
the availability of financing at reasonable levels and terms to support investing on a leveraged basis;
the availability of new investment capital;
the availability of suitable qualifying investments from both an investment return and regulatory perspective;
changes in legislation or regulation affecting Fannie Mae, Freddie Mac, Ginnie Mae, the Federal Home Loan Bank system and similar federal government agencies and related guarantees;
 
other changes in legislation or regulation affecting the mortgage and banking industries;
changes in market conditions as a result of Federal Reserve monetary policy or federal government fiscal challenges;
deterioration in credit quality and ratings of existing or future issuances of Fannie Mae, Freddie Mac or Ginnie Mae securities;
changes in legislation or regulation affecting exemptions for mortgage REITs from regulation under the Investment Company Act of 1940; and
increases in costs and other general competitive factors.

In addition to the above considerations, actual results and liquidity are affected by other risks and uncertainties which could cause actual results to be significantly different from those expressed or implied by any forward-looking statements included herein.  It is not possible to identify all of the risks, uncertainties and other factors that may affect future results.  In light of these risks and uncertainties, the forward-looking events and circumstances discussed herein may not occur and actual results could differ materially from those anticipated or implied in the forward-looking statements.  Forward-looking statements speak only as of the date the statement is made and the Company undertakes no obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.  Accordingly, readers of this document are cautioned not to place undue reliance on any forward-looking statements included herein.

ITEM 1A. RISK FACTORS

Under the captions “Risk Factors” and “Critical Accounting Policies” on pages 23 through 32 and 32 through 34, respectively, of Item 7 are discussions of risk factors and critical accounting policies affecting Capstead’s financial condition and results of operations that are an integral part of this report which are incorporated herein by reference.  Readers are strongly urged to consider the potential impact of these factors and accounting policies on the Company while reading this document.

ITEM 1B. UNRESOLVED STAFF COMMENTS

None.

ITEM 2. PROPERTIES

Capstead’s headquarters are located in Dallas, Texas in office space leased by the Company.

ITEM 3. LEGAL PROCEEDINGS

None.

ITEM 4. MINING SAFETY DISCLOSURES

Not applicable.
 
PART II

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

The New York Stock Exchange trading symbol for Capstead’s common stock is CMO. As of December 31, 2015, the Company had 1,139 common stockholders of record and depository companies held shares of common stock for 36,468 beneficial owners.
 
The high and low sales prices and dividends declared on Capstead’s common stock were as follows:

   
Year ended December 31, 2015
   
Year ended December 31, 2014
 
   
Sales Prices
   
Dividends
   
Sales Prices
   
Dividends
 
   
High
   
Low
   
Declared
   
High
   
Low
   
Declared
 
First quarter
 
$
12.58
   
$
11.55
   
$
0.31
   
$
13.15
   
$
11.97
   
$
0.34
 
Second quarter
   
12.01
     
11.04
     
0.31
     
13.43
     
12.52
     
0.34
 
Third quarter
   
11.75
     
9.71
     
0.26
     
13.32
     
12.20
     
0.34
 
Fourth quarter
   
10.54
     
8.64
     
0.26
     
13.14
     
12.24
     
0.34
 

Set forth below is a graph comparing the yearly percentage change in the cumulative total return on Capstead’s common stock, with the yearly percentage change in the cumulative total return of the Russell 2000 Index and the NAREIT Mortgage REIT Index for the five years ended December 31, 2015 assuming the investment of $100 on December 31, 2010 and the reinvestment of dividends.  The stock price and dividend performance reflected in the graph is not necessarily indicative of future performance.


   
Year ended December 31
 
   
2010
   
2011
   
2012
   
2013
   
2014
   
2015
 
Capstead Mortgage Corporation
 
$
100.00
   
$
113.41
   
$
117.11
   
$
136.37
   
$
154.10
   
$
122.10
 
Russell 2000 Index
   
100.00
     
95.82
     
111.49
     
154.78
     
162.35
     
155.18
 
NAREIT Mortgage REIT Index
   
100.00
     
97.58
     
116.99
     
114.70
     
135.21
     
123.21
 

See Item 11 of this report for information regarding equity compensation plans which is incorporated herein by reference.  Capstead did not issue any unregistered securities during the past three fiscal years.
 
ITEM 6. SELECTED FINANCIAL DATA
 
This table summarizes selected financial information, including key operating data (in thousands, except percentages, ratios and per share data).  For additional information, refer to the audited consolidated financial statements and notes thereto included under Item 8 and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” included under Item 7 of this report.
 
   
As of or for the year ended December 31
 
   
2015
   
2014
   
2013
   
2012
   
2011
 
Selected statement of income data:
                             
Interest income on residential mortgage investments (before investment premium amortization)
 
$
337,179
   
$
328,621
   
$
341,009
   
$
352,608
   
$
311,154
 
Investment premium amortization
   
(121,190
)
   
(101,872
)
   
(125,872
)
   
(96,677
)
   
(68,077
)
Related interest expense
   
(85,521
)
   
(65,155
)
   
(66,368
)
   
(69,101
)
   
(57,328
)
     
130,468
     
161,594
     
148,769
     
186,830
     
185,749
 
Other interest income (expense) (a)
   
(8,113
)
   
(8,173
)
   
(8,165
)
   
(7,790
)
   
(8,192
)
     
122,355
     
153,421
     
140,604
     
179,040
     
177,557
 
Other revenue (expense)
   
(14,030
)
   
(12,601
)
   
(14,117
)
   
(15,414
)
   
(17,353
)
Net income
 
$
108,325
   
$
140,820
   
$
126,487
   
$
163,626
   
$
160,204
 
Net income per diluted common share (b)
 
$
0.97
   
$
1.33
   
$
0.93
   
$
1.50
   
$
1.75
 
Cash dividends per share of common stock
   
1.14
     
1.36
     
1.24
     
1.49
     
1.76
 
Average number of diluted shares of common stock outstanding
   
95,701
     
95,629
     
95,393
     
95,012
     
79,696
 
                                         
Selected balance sheet data:
                                       
Residential mortgage investments
 
$
14,154,737
   
$
13,908,104
   
$
13,475,874
   
$
13,860,158
   
$
12,264,906
 
Total assets
   
14,446,366
     
14,386,951
     
14,013,751
     
14,466,947
     
12,842,204
 
Secured borrowings
   
12,958,394
     
12,806,843
     
12,482,900
     
12,784,238
     
11,352,444
 
Long-term investment capital (“LTIC”):
                                       
Unsecured borrowings (net of related investments in statutory trusts prior to dissolution in December 2013)
   
97,986
     
97,882
     
97,783
     
97,662
     
97,560
 
Preferred stockholders’ equity
   
197,172
     
183,936
     
165,756
     
188,992
     
184,514
 
Common stockholders’ equity
   
1,101,152
     
1,206,835
     
1,200,027
     
1,308,133
     
1,108,193
 
Book value per common share (unaudited)
   
11.42
     
12.52
     
12.47
     
13.58
     
12.52
 
                                         
Key operating data: (unaudited)
                                       
Portfolio acquisitions (principal amount)
   
3,761,789
     
3,191,256
     
3,187,534
     
4,206,459
     
5,673,803
 
Portfolio runoff (principal amount)
   
3,421,026
     
2,801,144
     
3,483,756
     
2,784,687
     
2,127,812
 
Common equity capital raised
   
     
     
     
142,036
     
231,673
 
Common stock repurchases
   
     
     
7,292
     
35,062
     
 
Year-end portfolio leverage ratio (c)
 
9.28:1
   
8.60:1
   
8.53:1
   
8.02:1
   
8.17:1
 
Average financing spreads on residential mortgage investments (d)
   
0.89
%
   
1.17
%
   
1.07
%
   
1.38
%
   
1.68
%
Average total financing spreads (d)
   
0.81
     
1.06
     
0.96
     
1.26
     
1.56
 
Average mortgage prepayment rates, (expressed as constant prepayment rates, or CPRs)
   
20.37
     
17.28
     
21.45
     
17.60
     
16.58
 
Return on average LTIC
   
7.91
     
9.97
     
8.73
     
11.00
     
13.16
 
Return on average common equity capital
   
7.86
     
10.37
     
7.08
     
11.15
     
13.94
 
 
(a) Consists principally of interest on unsecured borrowings and is presented net of earnings of related statutory trusts prior to dissolution in December 2013.
 
(b) Net income per diluted common share in 2013 includes reductions in net income available to common stockholders totaling $0.23 per common share related to convertible preferred stock redemption preference premiums paid and dividends accruing on then-outstanding shares of convertible preferred stock from the May 2013 initial issuance of the Company’s Series E preferred stock through the June 2013 redemption of the convertible preferred stock.
 
(c) Year-end portfolio leverage ratios were calculated by dividing secured borrowings by long-term investment capital.
 
(d) Financing spreads on residential mortgage investments is a non-GAAP financial measure based solely on yields on Capstead’s residential mortgage investments, net of secured borrowing rates adjusted for currently-paying interest rate swap agreements held for hedging purposes.  This measure differs from total financing spreads, an all-inclusive GAAP measure that includes yields on all interest-earning assets, as well as rates paid on all interest-bearing liabilities, principally unsecured borrowings.  See Item 7 on page 15 for the Company’s rationale for using this non-GAAP financial measure and a reconciliation to its related GAAP financial measure, total financing spreads.
 
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
Overview
 
Capstead operates as a self-managed REIT earning income from investing in a leveraged portfolio of residential mortgage pass-through securities consisting almost exclusively of short-duration ARM Agency Securities, which reset to more current interest rates within a relatively short period of time and are considered to have limited, if any, credit risk.  By investing in short-duration ARM Agency Securities, the Company is positioned to benefit from potential recoveries in financing spreads that typically contract during periods of rising interest rates and experience smaller fluctuations in portfolio values compared to leveraged portfolios containing a significant amount of longer-duration ARM or fixed-rate mortgage securities.  Duration is a common measure of market price sensitivity to interest rate movements.  A shorter duration generally indicates less interest rate risk.

Capstead finances its residential mortgage investments primarily by borrowing under repurchase arrangements with commercial banks and other financial institutions supported by its long-term investment capital.  In August 2015 the Company began supplementing its traditional borrowings with advances from the Federal Home Loan Bank (“FHLB”) of Cincinnati; however, in early 2016 the FHLB system regulator issued a ruling largely curtailing the mortgage REIT industry’s access to such advances.  In response, the Company has migrated all but $750 million of its $2.88 billion of FHLB advances outstanding at year-end back to repurchase arrangements as of February 26, 2016 and anticipates migrating remaining balances away from the FHLB by November 2016.

Long-term investment capital totaled $1.40 billion at December 31, 2015, consisting of $1.10 billion of common and $197 million of perpetual preferred stockholders’ equity and $98 million of unsecured borrowings that mature in 2035 and 2036 (recorded amounts).  Long-term investment capital decreased by $92 million during 2015 primarily as a result of lower unrealized portfolio gains ($98 million) and dividend distributions in excess of earnings ($16 million), partially offset by lower unrealized losses on interest rate swap agreements held for hedging purposes ($7 million), newly-issued Series E preferred capital ($13 million) and amounts related to long-term equity-based awards.  On January 27, 2016 Capstead’s board of directors authorized the repurchase of up to $100 million in common stock when such repurchases are deemed appropriate relative to portfolio reinvestment options and liquidity needs.  No shares were repurchased pursuant to this program as of February 26, 2016.

Capstead’s holdings of residential mortgage investments increased by $247 million to $14.15 billion during 2015 while secured borrowings increased by $152 million to $12.96 billion.  Portfolio leverage (secured borrowings divided by long-term investment capital) increased to 9.28 to one at December 31, 2015 from 8.60 to one at December 31, 2014.  Most of the increase in portfolio leverage was a consequence of the decline in long-term investment capital largely attributable to lower unrealized portfolio gains.  Management believes borrowing at current levels represents an appropriate use of leverage for a portfolio consisting of seasoned, short-duration ARM Agency Securities.

Capstead’s net income totaled $108 million or $0.97 per diluted common share in 2015, compared to $141 million or $1.33 per share in 2014.  Financing spreads on residential mortgage investments* averaged 0.89% during 2015, compared to 1.17% during 2014.  Net income and financing spreads were negatively affected by (a) increased investment premium amortization resulting from higher levels of mortgage prepayments primarily as a result of lower mortgage rates available earlier in 2015, and (b) higher unhedged borrowing rates and interest rate swap costs primarily attributable to expectations for Federal Reserve action to raise short-term interest rates, as well as greater use of higher-rate, longer-maturity secured borrowings.  Higher annual incentive compensation due in large part to the Company’s outperformance relative to its peers also contributed to lower earnings in 2015.

* As discussed in note (d) to page six, financing spreads on residential mortgage investments is a non-GAAP financial measure based solely on yields on residential mortgage investments, net of secured borrowing rates adjusted for currently-paying interest rate swap agreements held for hedging purposes.  See page 15 for further discussion and a reconciliation to the related GAAP financial measure, total financing spreads.
 
The size and composition of Capstead’s investment portfolio depends on investment strategies being implemented by management, as well as overall market conditions, including the availability of attractively priced investments and suitable financing to leverage the Company’s investment capital.  Market conditions are influenced by, among other things, current and future expectations for short-term interest rates, mortgage prepayments and market liquidity.
 
Risk Factors and Critical Accounting Policies
 
Under the captions “Risk Factors” and “Critical Accounting Policies” are discussions of risk factors and critical accounting policies affecting Capstead’s financial condition and earnings 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 and its financial results.
 
Book Value per Common Share
 
The following table illustrates the progression of Capstead’s book value per share of common stock as well as changes in book value expressed as percentages of beginning book value for the indicated periods:
 
   
As of and for the year ended December 31
 
   
2015
   
2014
   
2013
 
Book value per share of common stock,beginning of year
 
$
12.52
         
$
12.47
         
$
13.58
       
Change in unrealized gains and losses on mortgage securities classified as available-for-sale
   
(1.02
)
         
0.28
           
(1.05
)
     
Change in unrealized gains and losses on interest rate swap agreements designated as cash flow hedges of:
                                         
Secured borrowings
   
0.12
           
0.06
           
0.08
       
Unsecured borrowings
   
(0.05
)
         
(0.26
)
         
0.19
       
     
(0.95
)
    (7.6 )%    
0.08
      0.6 %    
(0.78
)
    (5.8 )%
Capital transactions:
                                               
Dividend distributions in excess of earnings available to common stockholders*
   
(0.17
)
           
(0.04
)
           
(0.08
)
       
Effects of preferred equity capital transactions
   
             
(0.01
)
           
(0.28
)
       
Accretion from common stock repurchases
   
             
             
0.01
         
Other (principally related to equity awards)
   
0.02
             
0.02
             
0.02
         
     
(0.15
)
    (1.2 )%    
(0.03
)
    (0.2 )%    
(0.33
)
    (2.4 )%
Book value per share of common stock,end of year
 
$
11.42
           
$
12.52
           
$
12.47
         
Change in book value per share of common stock during the indicated year
 
$
(1.10
)
    (8.8 )%  
$
0.05
      0.4 %  
$
(1.11
)
    (8.2 )%
 
* For this presentation, 2013 dividend distributions in excess of earnings available to common stockholders excludes one-time effects of transactions to redeem then-outstanding preferred stock.

During 2015 and 2013, Capstead’s book value per common share declined primarily because portfolio valuations weakened as a result of higher interest rates and underperformance relative to interest rate swaps held for hedging purposes.  Book values were also negatively affected by dividend distributions in excess of available earnings and one-time costs associated with the 2013 redemption of high-rate preferred stock.
 
Nearly all of Capstead’s residential mortgage investments and all of its interest rate swap agreements are recorded at fair value on the Company’s balance sheet and are therefore included in the calculation of book value per share of common stock (total stockholders’ equity, less liquidation preferences for outstanding shares of preferred stock, divided by outstanding shares of common stock).  The Company’s borrowings, however, are not recorded at fair value on the balance sheet.  Fair value is impacted by market conditions, including changes in interest rates, and the availability of financing at reasonable rates and leverage levels, among other factors.  The Company’s investment strategy attempts to mitigate these risks by focusing on investments in Agency Securities, which are considered to have little, if any, credit risk and are collateralized by ARM loans with interest rates that reset periodically to more current levels generally within five years.  Because of these characteristics, the fair value of the Company’s portfolio is considerably less vulnerable to significant pricing declines caused by credit concerns or rising interest rates compared to leveraged portfolios containing a significant amount of non-agency securities or longer-duration ARM and/or fixed-rate Agency Securities.
 
Newly Authorized $100 Million Common Stock Repurchase Program
 
On January 27, 2016 Capstead’s board of directors authorized the repurchase of up to $100 million in common stock when such repurchases are deemed appropriate relative to portfolio reinvestment options and liquidity needs.  Any repurchases made pursuant to the program will be made in the open market from time to time in accordance with and as permitted by securities laws and other legal requirements.  The timing, manner, price and amount of any repurchases will be determined by the Company in its discretion and will be subject to economic and market conditions, stock price, applicable legal requirements and other factors.  In addition, the Company may enter into Rule 10b5-1 plans under which repurchases can be made. The authorization does not obligate the Company to acquire any particular amount of common stock and repurchases under the program and the program itself may be suspended or discontinued at the Company’s discretion without prior notice.  No shares were repurchased pursuant to this program as of February 26, 2016.
 
Preferred Equity Capital Issuances
 
During the year ended December 31, 2015, Capstead issued 538,000 shares of its 7.50% Series E Cumulative Redeemable Preferred Stock through an at-the-market continuous offering program at an average price of $24.61, net of underwriting fees and other costs, for net proceeds of $13 million.  No shares were issued subsequent to year-end through February 26, 2016 pursuant to this program.  Additional amounts of equity capital may be raised in the future under continuous offering programs or by other means, subject to market conditions, compliance with federal securities laws and blackout periods associated with the dissemination of important Company-specific news.
 
Residential Mortgage Investments
 
Capstead’s investment strategy focuses on managing a large portfolio of residential mortgage investments consisting almost exclusively of ARM Agency Securities.  Agency Securities are considered to have limited, if any, credit risk because the timely payment of principal and interest is guaranteed by Fannie Mae and Freddie Mac, which are federally chartered corporations, or Ginnie Mae, which is an agency of the federal government.  Federal government support for Fannie Mae and Freddie Mac has largely alleviated market concerns regarding the ability of Fannie Mae and Freddie Mac to fulfill their guarantee obligations.

ARM securities are backed by residential mortgage loans that have coupon interest rates that adjust at least annually to more current interest rates or begin doing so after an initial fixed-rate period.  These coupon interest rate adjustments are usually subject to periodic and lifetime limits, or caps, on the amount of such adjustments during any single interest rate adjustment period and over the contractual term of the underlying loans.  After the initial fixed-rate period, if applicable, the coupon interest rates of mortgage loans underlying the Company’s ARM securities typically adjust either:
 
annually based on specified margins over the one-year Constant Maturity U.S. Treasury Note Rate (“CMT”) or the one-year London interbank offered rate (“LIBOR”),
 
semiannually based on specified margins over six-month LIBOR, or
 
monthly based on specified margins over indices such as one-month LIBOR, the Eleventh District Federal Reserve Bank Cost of Funds Index, or over a rolling twelve month average of the one-year CMT index.

By focusing on investing in short-duration ARM Agency Securities, changes in fair value caused by changes in interest rates are typically relatively modest compared to changes in fair value of longer-duration ARM or fixed-rate assets.  Declines in fair value caused by increases in interest rates are generally recoverable in a relatively short period of time as coupon interest rates on the underlying mortgage loans reset to rates more reflective of the then-current interest rate environment.  This investment strategy positions the Company to benefit from potential recoveries in financing spreads that typically contract during periods of rising interest rates.

The following table illustrates the progression of Capstead’s portfolio of residential mortgage investments for the indicated periods (dollars in thousands):

   
As of and for the year ended December 31
 
   
2015
   
2014
   
2013
 
Residential mortgage investments, beginning of year
 
$
13,908,104
   
$
13,475,874
   
$
13,860,158
 
Portfolio acquisitions (principal amount) at average lifetime purchased yields of 2.47%, 2.44% and 2.28%, respectively
   
3,761,789
     
3,191,256
     
3,187,534
 
Investment premiums on acquisitions*
   
125,262
     
116,707
     
138,811
 
Portfolio runoff (principal amount)
   
(3,421,026
)
   
(2,801,144
)
   
(3,483,756
)
Investment premium amortization*
   
(121,190
)
   
(101,872
)
   
(125,872
)
Change in net unrealized gains on securities classified as available-for-sale
   
(98,202
)
   
27,283
     
(101,001
)
Residential mortgage investments, end of year
 
$
14,154,737
   
$
13,908,104
   
$
13,475,874
 

* Residential mortgage investments typically are acquired at a premium to the securities’ unpaid principal balances.  Investment premiums are recognized in earnings as portfolio yield adjustments using the interest method over the estimated lives of the related investments.  The single largest determinant in amortizing investment premiums is actual portfolio runoff (scheduled and unscheduled principal paydowns) for a given accounting period.

Capstead classifies its ARM securities based on the average length of time until the loans underlying each security reset to more current rates (“months-to-roll”) (less than 18 months for “current-reset” ARM securities, and 18 months or greater for “longer-to-reset” ARM securities).  After consideration of any applicable initial fixed-rate periods, at December 31, 2015 approximately 88%, 7% and 5% of the Company’s ARM securities were backed by mortgage loans that reset annually, semi-annually and monthly, respectively.  Approximately 75% of the Company’s current-reset ARM securities have reached an initial coupon reset date, while none of its longer-to-reset ARM securities have reached an initial coupon reset date.  Additionally, at December 31, 2015 approximately 9% of the Company’s ARM securities were backed by interest-only loans, with remaining interest-only payment periods averaging 26 months.  All percentages are based on averages of the characteristics of mortgage loans underlying each security and calculated using unpaid principal balances as of the indicated date.
 
Capstead’s ARM holdings featured the following characteristics at December 31, 2015 (dollars in thousands):
 
 
 
ARM Type
 
Amortized
Cost Basis (a)
   
Net
WAC (b)
   
Fully
Indexed
WAC (b)
   
Average
Net
Margins (b)
   
Average
Periodic
Caps (b)
   
Average
Lifetime
Caps (b)
   
Months
To
Roll
 
Current-reset ARMs:
                                         
Fannie Mae Agency Securities
 
$
4,281,626
     
2.38
%
   
2.71
%
   
1.71
%
   
3.37
%
   
9.64
%
   
6.1
 
Freddie Mac Agency Securities
   
1,778,697
     
2.51
     
2.86
     
1.82
     
2.66
     
9.80
     
7.4
 
Ginnie Mae Agency Securities
   
1,898,650
     
2.41
     
2.17
     
1.51
     
1.07
     
8.40
     
6.9
 
Residential mortgage loans
   
2,661
     
3.39
     
2.77
     
2.04
     
1.59
     
10.98
     
4.8
 
(57% of total)
   
7,961,634
     
2.41
     
2.61
     
1.68
     
2.66
     
9.38
     
6.6
 
Longer-to-reset ARMs:
                                                       
Fannie Mae Agency Securities
   
2,223,412
     
2.75
     
2.82
     
1.64
     
3.65
     
7.77
     
40.0
 
Freddie Mac Agency Securities
   
2,048,211
     
2.73
     
2.85
     
1.67
     
2.85
     
7.80
     
44.6
 
Ginnie Mae Agency Securities
   
1,763,116
     
2.82
     
2.16
     
1.51
     
1.04
     
7.87
     
42.0
 
(43% of total)
   
6,034,739
     
2.77
     
2.64
     
1.61
     
2.61
     
7.81
     
42.2
 
   
$
13,996,373
     
2.57
     
2.62
     
1.65
     
2.64
     
8.70
     
21.9
 
                                                         
Gross WAC (rate paid by borrowers) (c)
           
3.17
                                         
 
(a) Amortized cost basis represents the Company’s investment (unpaid principal balance plus unamortized investment premiums) before unrealized gains and losses.  At December 31, 2015, the ratio of amortized cost basis to unpaid principal balance for the Company’s ARM holdings was 103.22.  This table excludes $4 million in fixed-rate Agency Securities, residential mortgage loans and private residential mortgage pass-through securities held as collateral for structured financings.
 
(b) Net WAC, or weighted average coupon, is the weighted average interest rate of the mortgage loans underlying the indicated investments, net of servicing and other fees as of the indicated date expressed as a percentage calculated on an annualized basis on the unpaid principal balances of the underlying mortgage loans.  As such, it is similar to the cash yield on the portfolio which is calculated using amortized cost basis.  Fully indexed WAC represents the weighted average coupon upon one or more resets using interest rate indexes and net margins as of the indicated date.  Average net margins represent the weighted average levels over the underlying indexes that the portfolio can adjust to upon reset, usually subject to initial, periodic and/or lifetime caps on the amount of such adjustments during any single interest rate adjustment period and over the contractual term of the underlying loans.  ARM securities with initial fixed-rate periods of five years or longer typically have either 200 or 500 basis point initial caps with 200 basis point periodic caps.  Additionally, some of the ARM securities held by the Company are subject only to lifetime caps or are not subject to a cap.  For presentation purposes, average periodic caps in the table above reflect initial caps until after an ARM security has reached its initial reset date and lifetime caps, less the current net WAC, for ARM securities subject only to lifetime caps.  At year-end, 65% of current-reset ARMs were subject to periodic caps averaging 1.75%; 25% were subject to initial caps averaging 3.32%; 9% were subject to lifetime caps averaging 7.58%; and 1% were not subject to a cap.  All longer-to-reset ARM securities at December 31, 2015 were subject to initial caps.
 
(c) Gross WAC is the weighted average interest rate of the mortgage loans underlying the indicated investments, including servicing and other fees paid by borrowers, as of the indicated date.

Secured Borrowings
 
Capstead finances its residential mortgage investments primarily by borrowing under repurchase arrangements with commercial banks and other financial institutions.  Repurchase arrangements entered into by the Company involve the sale and a simultaneous agreement to repurchase the transferred assets at a future date and are accounted for as financings.  The Company maintains the beneficial interest in the specific securities pledged during the term of each repurchase arrangement and receives the related principal and interest payments.

In August 2015 the Company began supplementing its borrowings under repurchase arrangements with advances from the FHLB of Cincinnati and as of December 31, 2015 these advances totaled $2.88 billion.  On January 12, 2016 the FHLB system regulator finalized rules originally proposed in 2014 that generally preclude captive insurers from remaining members beyond February 19, 2017 with transition rules that require outstanding advances to be repaid upon maturity or by that date.  In response to this action, the Company has reduced outstanding FHLB advances to $750 million as of February 26, 2016 and anticipates migrating remaining balances away from the FHLB by November 2016.  The Company’s ownership interest in FHLB stock held in connection with advance activity and totaling $60.0 million at December 31, 2015, is expected to be redeemed prior to December 31, 2016.
 
The terms and conditions of secured borrowings are negotiated on a transaction-by-transaction basis when each such borrowing is initiated or renewed.  None of the Company’s counterparties are obligated to renew or otherwise enter into new borrowings at the conclusion of existing borrowings. Collateral requirements in excess of amounts borrowed (referred to as “haircuts”) averaged 3.9 percent and ranged from 2.0 to 5.0 percent of the fair value of pledged residential mortgage pass-through securities at December 31, 2015.  After considering haircuts and related interest receivable on the collateral, as well as interest payable on these borrowings, the Company had $600 million of capital at risk with its lending counterparties at December 31, 2015.  The Company had capital at risk with the FHLB of Cincinnati of 7.0% at December 31, 2015.  The Company did not have capital at risk with any other counterparty exceeding 5.0% at December 31, 2015.

Secured borrowing rates are generally fixed based on prevailing rates corresponding to the terms of the borrowings. Interest may be paid monthly or at the termination of a borrowing at which time the Company may enter into a new borrowing at prevailing haircuts and rates with the same counterparty or repay that counterparty and negotiate financing with a different counterparty.  When the fair value of pledged securities declines due to changes in market conditions or the publishing of monthly security pay-down factors, lenders typically require the Company to post additional securities as collateral, pay down borrowings or fund cash margin accounts with the counterparties in order to re-establish the agreed-upon collateral requirements, referred to as margin calls.  Conversely, if collateral fair values increase, lenders are required to release collateral back to the Company pursuant to Company-issued margin calls.

As of December 31, 2015 the Company’s secured borrowings totaled $12.96 billion with 22 counterparties at average rates of 0.62%, before the effects of currently-paying interest rate swap agreements held as cash flow hedges and 0.85% including the effects of these derivatives. To help mitigate exposure to rising short-term interest rates, the Company uses pay-fixed, receive-variable interest rate swap agreements with two-year interest payment terms supplemented with longer-maturity secured borrowings, when available at attractive rates and terms.  Excluding $1.70 billion notional amount of swap agreements that expired January 4, 2016, at year-end the Company held $6.70 billion notional amount of portfolio financing-related interest rate swap agreements with contract expirations occurring at various dates through the first quarter of 2018 and a weighted average expiration of 13 months.  Secured borrowings with remaining maturities of greater than six months totaled $1.55 billion at year-end with a weighted average remaining maturity of eight months.

After consideration of all portfolio financing-related swap positions entered into as of year-end, the Company’s residential mortgage investments and secured borrowings had estimated durations at December 31, 2015 of 11¾ and 8 months, for a net duration gap of approximately 3¾ months – see pages 21 and 22 under the caption “Interest Rate Risk” for further information about the Company’s sensitivity to changes in market interest rates.  The Company intends to continue to manage interest rate risk associated with holding and financing its residential mortgage investments by utilizing suitable derivative financial instruments such as interest rate swap agreements as well as longer-maturity secured borrowings, if available at attractive rates and terms.
 
Analysis of Quarterly Financing Spreads
 
Components of quarterly financing spreads on residential mortgage investments, a non-GAAP financial measure, and mortgage prepayment rates, were as follows for the indicated periods:

   
2015
   
2014
 
     
Q4
     
Q3
     
Q2
     
Q1
     
Q4
     
Q3
     
Q2
     
Q1
 
                                                                 
Yields on residential mortgage investments:(a)
                                                               
Cash yields
   
2.44
%
   
2.42
%
   
2.41
%
   
2.42
%
   
2.43
%
   
2.44
%
   
2.46
%
   
2.46
%
Investment premium amortization
   
(0.81
)
   
(0.99
)
   
(0.95
)
   
(0.72
)
   
(0.77
)
   
(0.84
)
   
(0.75
)
   
(0.67
)
Adjusted yields
   
1.63
     
1.43
     
1.46
     
1.70
     
1.66
     
1.60
     
1.71
     
1.79
 
Secured borrowing rates:(b)
                                                               
Unhedged borrowing rates
   
0.48
     
0.45
     
0.41
     
0.38
     
0.36
     
0.32
     
0.32
     
0.34
 
Fixed swap rates
   
0.62
     
0.57
     
0.55
     
0.53
     
0.51
     
0.50
     
0.49
     
0.50
 
Adjusted borrowing rates
   
0.73
     
0.69
     
0.62
     
0.59
     
0.56
     
0.51
     
0.49
     
0.49
 
Financing spreads on residential mortgage investments(c)
   
0.90
     
0.74
     
0.84
     
1.11
     
1.10
     
1.09
     
1.22
     
1.30
 
Annualized constant prepayment rate (“CPR”)
   
19.62
     
23.21
     
21.98
     
16.66
     
17.58
     
19.18
     
17.22
     
15.16
 

(a) Cash yields are based on the cash component of interest income.  Investment premium amortization is determined using the interest method which incorporates actual and anticipated future mortgage prepayments.  Both are expressed as a percentage calculated on average amortized cost basis for the indicated periods.
 
(b) Unhedged borrowing rates represent average rates on secured borrowings, before consideration of related currently-paying interest rate swap agreements held for portfolio hedging purposes.
 
Fixed swap rates represent the average fixed payment rates on currently-paying interest rate swap agreements held for portfolio hedging purposes and exclude differences between LIBOR-based variable receive rates on these swaps and unhedged borrowing rates, as well as the effects of any hedge ineffectiveness.  These factors averaged 24 and 18 basis points on the average currently-paying swap notional amounts outstanding during 2015 and 2014, respectively.
 
Adjusted borrowing rates reflect unhedged borrowing rates, fixed swap rates and the above-mentioned factors, calculated on average secured borrowings outstanding for the indicated periods.
 
(c) See page 15 for the Company’s rationale for using this non-GAAP financial measure and a reconciliation to its related GAAP financial measure, total financing spreads.

Cash yields began increasing during 2015 (after years of declines) primarily due to increases in the underlying indexes (principally one-year LIBOR) in anticipation of Federal Reserve action to increase short-term interest rates.  For example, one-year LIBOR increased 55 basis points during 2015 to 1.18% at December 31, 2015, with most of the increase occurring during the fourth quarter.  Portfolio yield adjustments for investment premium amortization are primarily driven by mortgage prepayment and investment premium levels.  Mortgage prepayment levels are influenced by the availability of mortgage financing at attractive terms and the overall health of the housing markets as well as seasonal factors.  Mortgage prepayments began increasing in March of 2015 primarily as a result of lower mortgage rates available earlier in the year as well as seasonal factors, leading to higher investment premium amortization and lower yields during the second and third quarters of 2015.  Mortgage prepayment rates reached 23.93% CPR in July 2015 before beginning to subside, with December reported at 17.96% CPR.

Unhedged borrowing rates increased over the course of 2015, largely attributable to market conditions, including expectations for Federal Reserve action to raise short-term interest rates and more use of higher-rate, longer-maturity secured borrowings.  Fixed swap rates also increased during 2015 as expiring swap contracts were replaced at higher rates.
 
Utilization of Long-term Investment Capital and Potential Liquidity
 
Capstead’s investment strategy involves managing an appropriately leveraged portfolio of ARM Agency Securities that management believes can produce attractive risk-adjusted returns over the long term, while reducing, but not eliminating, sensitivity to changes in interest rates.  Secured borrowings generally can be increased or decreased on a daily basis to meet cash flow requirements and otherwise manage capital resources efficiently.  Consequently, potential liquidity inherent in the Company’s unencumbered residential mortgage investments is as important as the actual level of cash and cash equivalents carried on the balance sheet.  Potential liquidity is affected by, among other factors:
 
· current portfolio leverage levels,
· changes in market value of assets pledged and interest rate swap agreements held for hedging purposes as determined by lending and swap counterparties,
· mortgage prepayment levels,
· collateral requirements of lending and swap counterparties, and
· general conditions in the commercial banking and mortgage finance industries.

Future levels of portfolio leverage will be dependent on many factors, including the size and composition of the Company’s investment portfolio (see “Liquidity and Capital Resources”).  The Company’s utilization of its long-term investment capital and its estimated potential liquidity were as follows as of December 31, 2015 in comparison with December 31, 2014 (in thousands):

   
Investments (a)
   
Secured
Borrowings
   
Capital
Employed
   
Potential
Liquidity (b)
 
Portfolio
Leverage
Balances as of December 31, 2015:
                             
Residential mortgage investments
 
$
14,154,737
   
$
12,958,394
   
$
1,196,343
   
$
648,696
   
Cash collateral receivable from swap counterparties, net (c)
                   
31,852
     
   
Other assets, net of other liabilities
                   
168,115
     
54,185
   
                   
$
1,396,310
   
$
702,881
 
9.28:1
Balances as of December 31, 2014
 
$
13,908,104
   
$
12,806,843
   
$
1,488,653
   
$
753,575
 
8.60:1

(a) Investments are stated at balance sheet carrying amounts, which generally reflect estimated fair value as of the indicated dates.
 
(b) Potential liquidity is based on maximum amounts of borrowings available under existing uncommitted financing arrangements considering management’s estimate of the fair value of residential mortgage investments held as of the indicated dates adjusted for other sources of liquidity such as cash and cash equivalents.
 
(c) Cash collateral receivable from swap counterparties is presented net of cash collateral payable to swap counterparties, if applicable, and the fair value of interest rate swap positions as of the indicated date.

In order to efficiently manage its liquidity and capital resources, Capstead attempts to maintain sufficient liquidity reserves to fund borrowing and interest rate swap margin calls under stressed market conditions, including margin calls resulting from monthly principal payments (remitted to the Company 20 to 45 days after any given month-end), as well as reasonably possible declines in the market value of pledged assets and swap positions.  Should market conditions deteriorate, management may reduce portfolio leverage and increase liquidity by raising new equity capital, selling mortgage securities and/or curtailing the replacement of portfolio runoff.  Additionally, the Company routinely does business with a large number of lending counterparties, which bolsters financial flexibility to address challenging market conditions and limits exposure to any individual counterparty.

At December 31, 2015 portfolio leverage increased from the prior year-end, primarily reflecting a decline in long-term investment capital attributed to lower unrealized portfolio gains.  Management believes current portfolio leverage levels represent an appropriate use of leverage under current market conditions for a portfolio consisting of seasoned, short-duration ARM Agency Securities.
 
Reconciliation of GAAP and non-GAAP Financing Spread Disclosures
 
Financing spreads on residential mortgage investments differ from total financing spreads, an all-inclusive GAAP measure, that is based on all interest-earning assets and liabilities.  Management believes presenting financing spreads on residential mortgage investments provides useful information for evaluating portfolio performance.  The following reconciles these measures for the indicated periods:
 
   
2015
   
2014
 
     
Q4
     
Q3
     
Q2
     
Q1
     
Q4
     
Q3
     
Q2
     
Q1
 
Financing spreads on residential mortgage investments
   
0.90
%
   
0.74
%
   
0.84
%
   
1.11
%
   
1.10
%
   
1.09
%
   
1.22
%
   
1.30
%
Impact of lower yields on other interest-earning assets*
   
(0.01
)
   
(0.03
)
   
(0.04
)
   
(0.04
)
   
(0.05
)
   
(0.04
)
   
(0.05
)
   
(0.04
)
Impact of higher borrowing rates on other interest-paying liabilities*
   
(0.06
)
   
(0.05
)
   
(0.06
)
   
(0.06
)
   
(0.07
)
   
(0.06
)
   
(0.07
)
   
(0.07
)
Total financing spreads
   
0.83
     
0.66
     
0.74
     
1.01
     
0.98
     
0.99
     
1.10
     
1.19
 
 
   
2015
   
2014
   
2013
   
2012
   
2011
 
Financing spreads on residential mortgage investments
   
0.89
%
   
1.17
%
   
1.07
%
   
1.38
%
   
1.68
%
Impact of lower yields on other interest-earning assets*
   
(0.03
)
   
(0.05
)
   
(0.04
)
   
(0.06
)
   
(0.04
)
Impact of higher borrowing rates on other interest-paying liabilities*
   
(0.05
)
   
(0.06
)
   
(0.07
)
   
(0.06
)
   
(0.08
)
Total financing spreads
   
0.81
     
1.06
     
0.96
     
1.26
     
1.56
 

* Other interest-earning assets consist of overnight investments and cash collateral receivable from interest rate swap counterparties. Other interest-paying liabilities consist of unsecured borrowings (at an average borrowing rate of 8.63% for 2015) and cash collateral payable to interest rate swap counterparties.
 
Tax Considerations of Capstead Common and Preferred Stock Dividends
 
Capstead’s common and preferred dividend distributions are generally characterized as ordinary income or nontaxable return of capital based on the relative amounts of the Company’s earnings and profits (taxable income, with certain prescribed adjustments) to total distributions applicable for a given tax year.  Total distributions are determined in accordance with the spillover distribution provisions of IRC 857(b)(9).  Under IRC 857(b)(9), REIT common dividends declared in the fourth quarter of a calendar year with a record date prior to year-end and a payable date in January of the following year will be included in total distributions in the year declared only to the extent of available earnings and profits.  As a result, such fourth quarter common dividends may be pro-rated between tax years or may not be taxable until the following year.  While REIT preferred dividends are subject to the same spillover provisions, proration between tax years usually results in 100% of such dividends being included in total distributions in the year declared.

In accordance with IRC 857(b)(9), $0.226769 of Capstead’s fourth quarter 2014 common dividend of $0.34 paid in January 2015 was taxable in 2014 and the remaining $0.113231 is subject to tax in 2015.  This spillover distribution, together with common dividend distributions paid with respect to the first three quarters of 2015 and preferred dividend distributions paid for all of 2015 exceeded the Company’s available earnings and profits for 2015.  Therefore, none of the $0.26 fourth quarter 2015 common dividend paid in January 2016 is taxable in 2015.
 
The 2015 common and preferred dividend distributions described above exceeded 2015 earnings and profits by $0.023792, representing 2.40% of total 2015 common distributions of $0.993231.  This nondividend distribution is characterized as return of capital and has been allocated on a pro rata basis to each 2015 common dividend distribution.  Remaining 2015 common dividend distributions totaling $0.969439 have been characterized as ordinary income.  Nondividend distributions characterized as return on capital reduce the tax basis of related shares and are nontaxable to the recipient unless return of capital distributions in aggregate exceed tax cost basis, in which case the excess is reportable as capital gain.

All preferred dividends taxable in 2015 have been characterized as ordinary income.  All common and preferred dividends taxable in 2014 and 2013 were characterized as ordinary income.  See the investor relations section of the Company’s website at www.capstead.com or www.capstead.reit for quarterly dividend characterization information for years 2000 through 2015.

If the Company was to realize gains on sales of assets, a portion of its dividends may be characterized as long-term capital gains, provided such gains exceed the Company’s $21 million in capital loss carryforwards that expire after 2019.  Any such capital gain distributions would be reported as long-term capital gains and would generally be taxed at lower rates than distributions of ordinary income.

Due to the complex nature of applicable tax rules, it is recommended that stockholders consult their tax advisors to ensure proper tax treatment of dividends received.
 
Off-Balance Sheet Arrangements and Contractual Obligations
 
As of December 31, 2015, Capstead did not have any off-balance sheet arrangements.  The Company’s contractual obligations at December 31, 2015 were as follows (in thousands):
 
   
Payments Due by Period*
 
   
Total
   
12 Months
or Less
   
13 – 36
Months
   
37 – 60
Months
   
>Than
60 Months
 
Secured borrowings
 
$
12,981,802
   
$
12,880,578
   
$
100,847
   
$
265
   
$
112
 
Unsecured borrowings
   
220,009
     
5,058
     
10,063
     
11,113
     
193,775
 
Interest rate swap agreements designated as cash flow hedges of:
                                       
Secured borrowings
   
11,591
     
11,591
     
     
     
 
Unsecured borrowings
   
29,662
     
2,418
     
4,863
     
3,738
     
18,643
 
Portfolio acquisitions settling subsequent to year-end
   
77,010
     
77,010
     
     
     
 
Corporate office lease
   
1,320
     
282
     
587
     
451
     
 
   
$
13,321,394
   
$
12,976,937
   
$
116,360
   
$
15,567
   
$
212,530
 
 
* Secured borrowings include an interest component based on contractual rates in effect at year-end.  Unsecured borrowings include an interest component based on market interest rate expectations as of year-end.  Obligations under interest rate swap agreements are net of variable-rate payments owed to the Company under the agreements’ terms that are based on market interest rate expectations as of year-end.
 
RESULTS OF OPERATIONS
 
   
Year ended December 31
 
   
2015
   
2014
   
2013
 
Income statement data  (in thousands, except per share data)
                 
Interest income on residential mortgage investments (before investment premium amortization)
 
$
337,179
   
$
328,621
   
$
341,009
 
Investment premium amortization
   
(121,190
)
   
(101,872
)
   
(125,872
)
Related interest expense
   
(85,521
)
   
(65,155
)
   
(66,368
)
     
130,468
     
161,594
     
148,769
 
Other interest income (expense)
   
(8,113
)
   
(8,173
)
   
(8,165
)
     
122,355
     
153,421
     
140,604
 
Other revenue (expense):
                       
Salaries and benefits
   
(4,392
)
   
(4,112
)
   
(3,962
)
Short-term incentive compensation
   
(4,112
)
   
(2,115
)
   
(3,565
)
Long-term incentive compensation
   
(1,696
)
   
(2,075
)
   
(1,814
)
Other general and administrative expense
   
(4,798
)
   
(4,157
)
   
(4,476
)
Miscellaneous other revenue (expense)
   
968
     
(142
)
   
(300
)
     
(14,030
)
   
(12,601
)
   
(14,117
)
Net income
 
$
108,325
   
$
140,820
   
$
126,487
 
Net income per diluted common share
 
$
0.97
   
$
1.33
   
$
0.93
 
Average diluted shares outstanding
   
95,701
     
95,629
     
95,393
 
Key operating statistics  (dollars in millions)
                       
Average yields:
                       
Residential mortgage investments:
                       
Cash yields
   
2.42
%
   
2.45
%
   
2.52
%
Investment premium amortization
   
(0.87
)
   
(0.76
)
   
(0.93
)
Adjusted yields
   
1.55
     
1.69
     
1.59
 
Other interest-earning assets
   
0.13
     
0.08
     
0.10
 
Total average yields
   
1.52
     
1.64
     
1.55
 
Average borrowing rates:
                       
Secured borrowings:
                       
Unhedged borrowing rates
   
0.43
     
0.34
     
0.39
 
Fixed swap rates
   
0.57
     
0.50
     
0.62
 
Adjusted borrowing rates
   
0.66
     
0.52
     
0.52
 
Unsecured borrowings
   
8.63
     
8.68
     
8.69
 
Total average borrowing rates
   
0.71
     
0.58
     
0.59
 
Average financing spreads on residential mortgage investments, a non-GAAP financial measure *
   
0.89
     
1.17
     
1.07
 
Average total financing spreads
   
0.81
     
1.06
     
0.96
 
Average net yield on total interest-earning assets
   
0.86
     
1.11
     
1.01
 
Average CPR
   
20.37
     
17.28
     
21.45
 
Average balance information:
                       
Residential mortgage investments (cost basis)
 
$
13,923
   
$
13,424
   
$
13,551
 
Other interest-earning assets
   
265
     
398
     
336
 
Secured borrowings
   
13,048
     
12,651
     
12,703
 
Currently-paying swap agreements (notional amounts)
   
7,699
     
6,548
     
3,999
 
Unsecured borrowings **
   
98
     
98
     
98
 
Long-term investment capital (“LTIC”)
   
1,477
     
1,498
     
1,545
 
Portfolio leverage
 
8.83:1
   
8.45:1
   
8.22:1
 
Operating costs as a percentage of average LTIC
   
1.02
%
   
0.83
%
   
0.89
%
Return on average LTIC
   
7.91
     
9.97
     
8.73
 
Return on average common equity capital
   
7.86
     
10.37
     
7.08
 
 
* See page 15 for the Company’s rationale for using this non-GAAP financial measure and a reconciliation to its related GAAP financial measure, total financing spreads.
 
**
Included in long-term investment capital and presented net of related investments in statutory trusts prior to dissolution in December 2013.
 
2015 Compared to 2014
 
Capstead’s net income totaled $108 million or $0.97 per diluted common share for the year ended December 31, 2015, compared to $141 million or $1.33 per diluted common share in 2014.  Earnings were lower in 2015 reflecting decreased net interest margins primarily as a result of higher investment premium amortization caused by higher mortgage prepayment levels, lower cash yields on the portfolio and higher borrowing costs.  Higher compensation as well as other general and administrative expenses also contributed to lower earnings in 2015.

Financing spreads on residential mortgage investments averaged 0.89% during 2015, compared to 1.17% reported for 2014.  Financing spreads on residential mortgage investments is a non-GAAP financial measure based solely on yields on residential mortgage investments, net of secured borrowing rates adjusted for currently-paying interest rate swap agreements held for hedging purposes.  See page 15 for the Company’s rationale for using this non-GAAP financial measure and a reconciliation to its related GAAP financial measure, total financing spreads.

Yields on residential mortgage investments averaged 1.55% during 2015, 14 basis points lower than yields reported for 2014.  Cash yields averaged 2.42% during 2015, three basis points lower than reported for 2014, primarily as a result of ARM loan coupon interest rates resetting lower to more current rates as well as lower coupon interest rates on acquisitions.  In large part due to market expectations for higher short-term interest rates, cash yields began increasing the latter half of 2015 reflecting increases during 2015 in the underlying indexes (principally one-year LIBOR) in anticipation of Federal Reserve action to increase short-term interest rates.  The yield adjustment for investment premium amortization averaged 87 basis points during 2015, 11 basis points higher than reported for 2014.  This increase is primarily the result of higher levels of mortgage prepayments in 2015 compared to prepayment levels experienced in 2014 which resulted in a $19 million increase in premium amortization.  Mortgage prepayment levels are influenced by the availability of mortgage financing at attractive terms and the health of the housing markets as well as seasonal factors.  Mortgage prepayments began increasing in March 2015 primarily as a result of lower mortgage rates then available as well as seasonal factors, leading to higher investment premium amortization and lower yields during the second and third quarters of 2015.  Mortgage prepayment rates reached 23.93% CPR in July 2015 before beginning to subside, with December 2015 reported at 17.96% CPR.

Secured borrowing rates adjusted for currently-paying interest rate swap agreements held for hedging purposes averaged 0.66% in 2015, 14 basis points higher than reported for 2014.  Unhedged borrowing rates accounted for most of the increase, with the remainder attributable to higher interest rate swap costs.  Market conditions, including expectations for Federal Reserve action to raise short-term interest rates, contributed to higher borrowing rates as well as greater use of higher-rate, longer-maturity secured borrowings. Swap costs were impacted by the expiration of older, lower-rate swaps and higher currently-paying swap balances (currently-paying swap balances averaged $7.70 billion in 2015, compared to $6.55 billion for the same period in 2014).  Note that fixed swap rates exclude differences between LIBOR-based variable-rate payments received on these swaps and designated 30- to 90-day unhedged borrowing rates, as well as the effects of hedge ineffectiveness.  These factors averaged 24 and 18 basis points on average currently-paying swap notional amounts outstanding during 2015 and 2014, respectively.  The larger impact of these factors in 2015 compared to the prior year was caused primarily by greater spreads between 30- to 90-day secured borrowing rates and one-month LIBOR rates.  Future secured borrowing rates will be dependent on market conditions, including overall levels of market interest rates as well as the availability of longer-maturity borrowings and interest rate swap agreements at attractive rates.

Operating costs as a percentage of long-term investment capital averaged 1.02% for 2015, 19 basis points higher than reported for 2014 primarily because of higher compensation-related expenses, particularly costs associated with short-term incentive compensation programs.  As further described in NOTE 12 to the accompanying consolidated financial statements (included in Item 8 of this report), results under these programs are based in part on relative economic return performance metrics.  Economic return is defined as the change in book value per share of common stock plus common stock dividends declared divided by beginning book value per share.  Capstead’s 2015 economic return exceeded that of most of its mortgage REIT peers whereas this was not the case in 2014.
 
Miscellaneous other revenue increased in 2015 compared to 2014 primarily due to the inclusion of dividends on FHLB stock acquired by the Company beginning in August 2015 in connection with FHLB advance activity.
 
2014 Compared to 2013
 
Capstead’s net income totaled $141 million or $1.33 per diluted common share for the year ended December 31, 2014, compared to $126 million or $0.93 per diluted common share in 2013.  Net income per diluted common share for 2013 includes reductions in net income available to common stockholders totaling $0.23 pertaining to one-time effects of transactions to redeem then-outstanding preferred stock.  Earnings were higher in 2014 as a result of improved net interest margins primarily because of lower investment premium amortization caused by lower mortgage prepayment levels and slightly lower borrowing costs, partially offset by lower cash yields on the portfolio.  Lower short-term incentive compensation program costs also contributed to higher earnings in 2014.

Financing spreads on residential mortgage investments averaged 1.17% during 2014, compared to 1.07% reported for 2013.  See page 15 for the Company’s rationale for using this non-GAAP financial measure and a reconciliation to its related GAAP financial measure, total financing spreads.

Yields on residential mortgage investments averaged 1.69% during 2014, ten basis points higher than yields reported for 2013.  Cash yields averaged 2.45% during 2014, seven basis points lower than in 2013 primarily as a result of ARM loan coupon interest rates resetting lower to rates then in effect as well as lower coupon interest rates on acquisitions.  The rate of decline in cash yields slowed in 2014 as more loans underlying the portfolio reset to fully-indexed levels.  The yield adjustment for investment premium amortization averaged 76 basis points during 2014, an improvement of 17 basis points over 2013.  Investment premium amortization declined by $24 million, as a result of a 4.17% CPR decline in mortgage prepayment rates to an average CPR of 17.28% for the year.  Lower mortgage prepayment levels were largely attributable to higher prevailing mortgage interest rates during 2014 compared to rates that were available during the first half of 2013, which made it less economically advantageous for borrowers to refinance.

Secured borrowing rates, adjusted for currently-paying interest rate swap agreements held for hedging purposes, were lower by less than one basis point, averaging 0.52% during 2014.  Unhedged borrowing rates averaged 0.34% during 2014, five basis points lower than rates reported for 2013.  This decline in rates was realized even as the Company took advantage of healthy market conditions by securing $1.78 billion in 12- and 18-month secured borrowings at average rates of 0.56% during the latter half of 2014.  The benefits to adjusted borrowing rates from lower unhedged borrowing rates were largely negated by a greater percentage of swap agreements moving into current-pay status, even as average fixed swap rates declined from rates in effect during the prior year with the expiration of older, higher-rate swaps.  Currently-paying swap balances averaged $6.55 billion during 2014, compared to $4.00 billion for 2013.  Differences between LIBOR-based variable-rate payments received on swaps and designated 30- to 90-day unhedged borrowing rates, as well as the effects of any hedge ineffectiveness averaged 18 and 19 basis points during 2014 and 2013, respectively.

Operating costs as a percentage of long-term investment capital averaged 0.83% for 2014, six basis points lower than reported for 2013, primarily due to lower costs associated with short-term incentive compensation programs as the Company’s 2014 relative economic return performance trailed most of its mortgage REIT peers after having exceeded most peers in 2013.
 
LIQUIDITY AND CAPITAL RESOURCES

Capstead’s primary sources of funds are secured borrowings and monthly principal and interest payments on its investments. Other sources of funds may include proceeds from debt and equity offerings and asset sales. The Company generally uses its liquidity to pay down secured borrowings to reduce borrowing costs and otherwise efficiently manage its long-term investment capital. Because the level of these borrowings can generally be adjusted on a daily basis, the Company’s potential liquidity inherent in its unencumbered residential mortgage investments is as important as the level of cash and cash equivalents carried on the balance sheet. The table included under “Utilization of Long-term Investment Capital and Potential Liquidity” on page 14 illustrates management’s estimate of additional funds potentially available to the Company as of December 31, 2015 and the accompanying discussion provides insight into the Company’s perspective on the appropriate level of portfolio leverage to employ under current market conditions. The Company currently believes that it has sufficient liquidity and capital resources available for the acquisition of additional investments, repayments on borrowings and the payment of cash dividends as required for the Company’s continued qualification as a REIT.

On January 27, 2016 Capstead’s board of directors authorized the repurchase of up to $100 million in common stock when such repurchases are deemed appropriate relative to portfolio reinvestment options and liquidity needs. No shares were repurchased pursuant to this program as of February 26, 2016.

Capstead finances its residential mortgage investments primarily by borrowing under repurchase arrangements, the terms and conditions of which are negotiated on a transaction-by-transaction basis, when each such borrowing is initiated or renewed. In August 2015 the Company began supplementing its traditional borrowings with FHLB advances; however, in early 2016 the FHLB system regulator issued a ruling generally eliminating the mortgage REIT industry’s access to such advances. In response, the Company has migrated all but $750 million of its $2.88 billion of FHLB advances outstanding at year-end back to repurchase arrangements as of February 26, 2016 and anticipates migrating remaining balances away from the FHLB by November 2016. The Company’s ownership interest in FHLB stock held in connection with advance activity and totaling $60.0 million at December 31, 2015, is expected to be redeemed by December 31, 2016.

None of the Company’s borrowing counterparties are obligated to renew or otherwise enter into new borrowings at the conclusion of existing borrowings. Future borrowings are dependent upon the willingness of lenders to participate in the financing of Agency Securities, lender collateral requirements and the lenders’ determination of the fair value of the securities pledged as collateral, which fluctuates with changes in interest rates and liquidity conditions within the commercial banking and mortgage finance industries. Secured borrowings totaled $12.96 billion at December 31, 2015, with $11.06 billion maturing within 90 days. Secured borrowings began the year at $12.81 billion and averaged $13.05 billion during 2015. Average secured borrowings can differ from period-end balances for a number of reasons including portfolio growth or contraction, as well as differences in the timing of portfolio acquisitions relative to portfolio runoff.

To help mitigate exposure to rising short-term interest rates, the Company uses pay-fixed, receive-variable interest rate swap agreements with two-year interest payment terms supplemented with longer-maturity secured borrowings when available at attractive rates and terms. Excluding $1.70 billion notional amount of swap agreements that expired January 4, 2016, at year-end the Company held $6.70 billion notional amount of portfolio financing-related interest rate swap agreements with contract expirations occurring at various dates through the first quarter of 2018 and a weighted average expiration of 13 months. Secured borrowings with remaining maturities of greater than six months totaled $1.55 billion at year-end with a weighted average remaining maturity of eight months. Relative to the 20-year floating rate terms of the Company’s $100 million face amount of unsecured borrowings, the Company entered into forward-starting swap agreements to effectively lock in lower fixed rates of interest on these borrowings. The Company intends to continue to utilize suitable derivative financial instruments such as interest rate swap agreements and longer-maturity secured borrowings to manage interest rate risk when available at attractive rates and terms.
 
During 2015, Capstead issued 538,000 shares of its 7.50% Series E Cumulative Redeemable Preferred Stock through an at-the-market continuous offering program for net proceeds of $13 million. Additional amounts of Series E preferred capital and new common equity capital may be raised in the future under continuous offering programs or by other means. Any such capital raising activity will be subject to market conditions such as pricing levels for these securities, capital deployment opportunities or needs, the status of stock repurchase programs, if applicable, as well as compliance with federal securities laws and blackout periods associated with the dissemination of earnings and dividend announcements and other important Company-specific news.

Interest Rate Risk
 
Because Capstead’s residential mortgage investments consist almost entirely of Agency Securities, which are considered to have limited, if any, credit risk, interest rate risk is the primary market risk faced by the Company. Interest rate risk is highly sensitive to a number of factors, including economic conditions, government fiscal policy, central bank monetary policy and banking regulation. By focusing on investing in relatively short-duration ARM Agency Securities, declines in fair value caused by increases in interest rates are typically relatively modest compared to investments in longer-duration ARM or fixed-rate assets. These declines can be recovered in a relatively short period of time as coupon interest rates on the underlying mortgage loans reset to rates more reflective of the then-current interest rate environment. This strategy also positions the Company to benefit from potential recoveries in financing spreads that typically contract during periods of rising interest rates.

To further reduce exposure to higher short-term interest rates, the Company uses interest rate swap agreements that typically require interest payments for two-year terms, as well as longer-maturity secured borrowings, if available at attractive rates and terms. These transactions lengthen the effective duration of the Company’s secured borrowings to more closely match the duration of its portfolio of residential mortgage investments. After consideration of portfolio financing-related swap positions held to hedge changes in short-term interest rates, at December 31, 2015 the Company’s residential mortgage investments and secured borrowings had estimated durations of 11¾ and 8 months, respectively, for a net duration gap of approximately 3¾ months. The Company intends to continue to manage interest rate risk associated with holding and financing its residential mortgage investments by utilizing suitable derivative financial instruments such as interest rate swap agreements and longer-maturity secured borrowings, if available at attractive rates and terms.

Capstead performs sensitivity analyses using a model to estimate the effects that specific interest rate changes can reasonably be expected to have on net interest margins and portfolio values. All investments, secured borrowings and related derivative financial instruments held are included in these analyses. For net interest margin modeling purposes, the model incorporates management’s assumptions for mortgage prepayment levels for a given interest rate change using market-based estimates of prepayment speeds for the purpose of amortizing investment premiums and reinvesting portfolio runoff. These assumptions are developed through a combination of historical analysis and expectations for future pricing behavior under normal market conditions unaffected by changes in market liquidity. For portfolio valuation modeling purposes, a static portfolio is assumed.
 
This modeling is the primary tool used by management to assess the direction and magnitude of changes in net interest margins and portfolio values resulting solely from changes in interest rates. Key modeling assumptions include mortgage prepayment speeds, adequate levels of market liquidity, current market conditions, and portfolio leverage levels. Given the present low level of interest rates, a floor of 0.00% is assumed. However, it is assumed that borrowing rates cannot decline beyond a floor of 0.15%. These assumptions are inherently uncertain and, as a result, modeling cannot precisely estimate the impact of higher or lower interest rates. Actual results will differ from simulated results due to the timing, magnitude and frequency of interest rate changes, other changes in market conditions, changes in management strategies and other factors.
 
The table below reflects the estimated impact of instantaneous parallel shifts in the yield curve on net interest margins and the fair value of Capstead’s portfolio of residential mortgage investments and related derivative financial instruments at December 31, 2015 and 2014, subject to the modeling parameters described above.
 
   
Federal
Funds
Rate
   
10-year U.S.
Treasury
Rate
   
Down
0.50%
   
Up
0.50%
   
Up
1.00%
 
Projected 12-month percentage change in net interest margins: *
                               
December 31, 2015
   
0.25-0.50
%
   
2.27
%
   
(9.2
)%
   
(0.1
)%
   
(5.3
)%
December 31, 2014
 
 
<0.25
     
2.17
     
(21.5
)
   
7.1
     
9.5
 
                                         
Projected percentage change in portfolio and related derivative values: *
                                       
December 31, 2015
   
0.25-0.50
     
2.27
     
0.1
 
   
(0.3
)
   
(0.5
)
December 31, 2014
 
 
<0.25      
2.17
     
0.1
 
   
(0.2
)
   
(0.3
)

* Sensitivity of net interest margins as well as portfolio and related derivative values to changes in interest rates is determined relative to the actual rates at the applicable date. Note that the projected 12-month net interest margin change is predicated on acquisitions of similar assets sufficient to replace runoff. There can be no assurance that suitable investments will be available for purchase at attractive prices, if investments made will behave in the same fashion as assets currently held or if management will choose to replace runoff with such assets.

The projections for the 12-month percentage change in net interest margins at December 31, 2015 differ from the prior year for a number of reasons, including changes in portfolio leverage and composition of both the portfolio and interest rate swap/longer-dated secured borrowing positions at the indicated balance sheet dates, as well as timing differences associated with replacing expiring swaps and longer-dated secured borrowings at rates commensurate with the indicated rate scenarios.
 
RISK FACTORS

An investment in securities issued by Capstead involves various risks. An investor should carefully consider the following risk factors in conjunction with the other information contained in this document before purchasing the Company’s securities. The risks discussed herein can adversely affect the Company’s business, liquidity, operating results, financial condition and future prospects, causing the market price of the Company’s securities to decline, which could cause an investor to lose all or part of his/her investment. The risk factors described below are not the only risks that may affect the Company. Additional risks and uncertainties not presently known to the Company also may adversely affect its business, liquidity, operating results, prospects and financial condition.

Risks Related to Capstead’s Business

An increase in prepayments may adversely affect Capstead’s liquidity, financial condition and earnings. When short- and long-term interest rates are at nearly the same levels (i.e., a “flat yield curve” environment), or when long-term interest rates decrease, the rate of principal prepayments on mortgage loans underlying mortgage securities generally increases due to the availability of lower mortgage interest rates to homeowners. Mortgage interest rates and the general availability of mortgage credit can also be impacted by regulatory changes in Agency guarantee fees, loan level pricing adjustments, down payment requirements, as well as other underwriting requirements. Prolonged periods of high mortgage prepayments can significantly reduce the expected life of the Company’s portfolio of residential mortgage investments; therefore, actual yields the Company realizes can be lower due to faster amortization of investment premiums, which could adversely affect earnings. High levels of mortgage prepayments can also lead to larger than anticipated demands on the Company’s liquidity from its lending counterparties, as more fully described below. Additionally, periods of high prepayments can adversely affect pricing for Agency Securities in general and, as a result, book value per common share can be adversely affected due to declines in the fair value of the Company’s remaining portfolio and the elimination of any unrealized gains on that portion of the portfolio that prepays.

Changes in interest rates, whether increases or decreases, may adversely affect Capstead’s liquidity, financial condition and earnings. Capstead’s earnings depend primarily on the difference between the interest received on its residential mortgage investments and the interest paid on its secured borrowings, net of the effect of derivatives held for hedging purposes. The Company finances its investments primarily at 30- to 90-day interest rates. Coupon interest rates on only a portion of the ARM loans underlying the Company’s securities reset each month and the terms of these ARM loans generally limit the amount of any increases during any single interest rate adjustment period and over the life of a loan. Consequently, interest rates on secured borrowings not effectively fixed through the use of interest rate swap agreements can rise to levels that may exceed yields on these securities in a rising short-term interest rate environment. This can contribute to lower, or in more extreme circumstances, negative financing spreads and, therefore, adversely affect earnings. Because rising interest rates tend to put downward pressure on financial asset prices, Capstead may be presented with substantial margin calls during such periods, adversely affecting the Company’s liquidity. If the Company is unable or unwilling to pledge additional collateral, the Company’s lenders can liquidate the Company’s collateral, potentially under adverse market conditions, resulting in losses. At such times the Company may determine that it is prudent to sell assets to improve its ability to pledge sufficient collateral to support its remaining secured borrowings, which could result in losses. In addition, lower pricing levels for remaining holdings of residential mortgage investments will lead to declines in book value per common share.

During periods of relatively low short-term interest rates, declines in the indices used to determine coupon interest rate resets for ARM loans may adversely affect yields on the Company's 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.
 
In January 2016, the Federal Housing Finance Agency (“FHFA”) issued regulations excluding captive insurance companies from membership in the FHLB, which could adversely impact Capstead’s liquidity, financial condition and earnings.  In August 2015 Capstead began obtaining FHLB advances through a captive insurance subsidiary. The FHFA is the federal regulator of the FHLB system as well as Fannie Mae and Freddie Mac. In September 2014 the FHFA published a notice of proposed rulemaking regarding, among other matters, membership eligibility of captive insurance companies in the FHLB system. Under the final rule Capstead Insurance LLC’s membership in the FHLB Cincinnati will be terminated by February 19, 2017 and outstanding advances are required to be repaid when due between now and that date with no opportunity to enter into additional advances during this period. A number of other industry participants are similarly affected. Additionally, FHLB advances to industry participants scheduled to mature beyond February 19, 2017 will generally be due and payable on that date. This loss of an increasingly significant industry counterparty could result in constraints in available borrowing capacity leading to deteriorating market conditions, which could adversely affect the Company’s liquidity, earnings and book value per common share.

Periods of illiquidity in the mortgage markets may reduce amounts available under secured borrowing arrangements due to declines in the perceived value of related collateral, which could adversely impact Capstead’s liquidity, financial condition and earnings. Capstead finances its residential mortgage investments by pledging them as collateral under uncommitted secured borrowing arrangements. The amount borrowed is limited to a percentage of the market value of the pledged collateral and is specified at the inception of the transaction. The portion of the pledged collateral held by or pledged to the lender in excess of the amount borrowed is referred to as margin collateral and the resulting margin percentage is required to be maintained throughout the term of the borrowing. If the perceived market value of the pledged collateral as determined by the Company’s lenders declines, the Company may be subject to margin calls wherein the lender requires the Company to pledge additional collateral to reestablish the agreed-upon margin percentage. Because market illiquidity tends to put downward pressure on asset prices, the Company may be presented with substantial margin calls during such periods. If the Company is unable or unwilling to pledge additional collateral, lenders can liquidate the collateral or seek other remedies, potentially under adverse market conditions, resulting in losses. At such times the Company may determine that it is prudent to sell assets to improve its ability to pledge sufficient collateral to support its remaining secured borrowings, which could result in losses. In addition, lower pricing levels for remaining holdings of residential mortgage investments will lead to declines in book value per common share.

Periods of illiquidity in the mortgage markets may reduce the number of counterparties willing to lend to the Company and/or the amounts individual counterparties are willing to lend, which could adversely affect the Company’s liquidity, financial condition and earnings. Capstead enters into secured borrowing arrangements with numerous commercial banks and other financial institutions, both foreign and domestic, routinely with maturities of 30 to 90 days. The Company’s ability to achieve its investment objectives depends on its ability to re-establish or roll maturing secured borrowings on a continuous basis and none of the Company’s counterparties are obligated to enter into new borrowing transactions at the conclusion of existing transactions. If a counterparty chooses not to roll a maturing borrowing, the Company must pay off the borrowing, generally with cash available from another secured borrowing arrangement entered into with another counterparty. If the Company determines that it does not have sufficient borrowing capacity with its remaining counterparties, it could be forced to sell assets under potentially adverse market conditions, which could result in losses. An industry-wide reduction in the availability of secured borrowings could adversely affect pricing levels for Agency Securities leading to further declines in the Company’s liquidity and book value per common share. Under these conditions, the Company may determine that it is prudent to sell assets to improve its ability to pledge sufficient collateral to support its remaining borrowings, which could result in losses. In addition, lower pricing levels for remaining holdings of residential mortgage investments will lead to declines in book value per common share.
 
If Capstead is unable to negotiate favorable terms and conditions on future secured borrowings with one or more of the Company’s lending counterparties, the Company’s liquidity, financial condition and earnings could be adversely impacted. The terms and conditions of each secured borrowing arrangement are negotiated on a transaction-by-transaction basis. Key terms and conditions include interest rates, maturity dates, asset pricing procedures and margin requirements. The Company cannot assure investors that it will be able to continue to negotiate favorable terms and conditions on future secured borrowings. During periods of market illiquidity or due to perceived credit deterioration of the collateral pledged or the Company itself, a lender may require that less favorable asset pricing procedures be employed, margin requirements be increased and/or may choose to limit or completely curtail lending to the Company. Under these conditions, the Company may determine it is prudent to sell assets to improve its ability to pledge sufficient collateral to support its remaining secured borrowings, which could result in losses.

Capstead’s use of borrowings under repurchase arrangements may expose the Company to losses if a lending counterparty seeks bankruptcy protection, or otherwise defaults on its obligation to deliver pledged collateral back to the Company. Repurchase arrangements involve the sale and transfer of pledged collateral to the lending counterparty and a simultaneous agreement to repurchase the transferred assets at a future date. This may make it difficult for the Company to recover its pledged assets if a lender files for bankruptcy or otherwise fails to deliver pledged collateral back to the Company and subject the Company to losses to the extent of any margin amounts (pledged assets in excess of amounts borrowed) held by the lending counterparty.

Capstead’s use of borrowings under repurchase arrangements may give lending counterparties greater rights if the Company seeks bankruptcy protection, exposing the Company to losses. Borrowings under repurchase arrangements may qualify for special treatment under the U.S. Bankruptcy Code. If the Company files for bankruptcy, these lending counterparties could avoid the automatic stay provisions of the U.S. Bankruptcy Code and liquidate pledged collateral without delay, which could result in losses to the extent of any margin amounts held by the lending counterparties.

Capstead may sell assets for various reasons, including a change in the Company’s investment focus, which could increase earnings volatility. Capstead may periodically sell assets to enhance its liquidity during periods of market illiquidity or rising interest rates or the Company may change its investment focus requiring it to sell some portion of its existing investments. Gains or losses resulting from any such asset sales, or from terminating any related longer-maturity secured borrowings or interest rate swap agreements, could increase the Company’s earnings volatility.

Capstead may invest in derivative financial instruments such as interest rate swap agreements to mitigate or hedge the Company's interest rate risk, which may adversely affect the Company’s liquidity, financial condition or earnings.  The Company may invest in such instruments from time to time with the goal of achieving more stable borrowing costs over an extended period. However, these activities may not have the desired beneficial impact on the Company's liquidity, financial condition or earnings. For instance, the pricing of residential mortgage investments and the pricing of related derivatives may deteriorate at the same time leading to margin calls by counterparties to both the borrowings supporting these investments and the derivatives, adversely impacting the Company's liquidity and financial condition. In addition, counterparties could fail to honor their commitments under the terms of the derivatives or have their credit quality downgraded impairing the value of the derivatives. In the event of any defaults by counterparties, the Company may have difficulty recovering its cash collateral receivable from its counterparties and may not receive payments provided for under the terms of the derivatives and as a result, the Company may incur losses. No such hedging activity can completely insulate the Company from the risks associated with changes in interest rates and prepayment rates.
 
Derivative financial instruments held may fail to qualify for hedge accounting introducing potential volatility to Capstead’s earnings. The Company typically qualifies derivative financial instruments held as cash flow hedges for accounting purposes in order to record the effective portion of the change in fair value of derivatives as a component of stockholders’ equity rather than in earnings. If the hedging relationship for any derivative held ceases to qualify for hedge accounting treatment for any reason, including failing to meet documentation and ongoing hedge effectiveness requirements, the Company would be required to record in earnings the total change in fair value of any such derivative. In addition the Company could elect to no longer avail itself of cash flow hedge accounting for its derivative positions. Such changes could introduce a potentially significant amount of volatility to earnings reported by the Company.

The lack of availability of suitable investments at attractive pricing may adversely affect Capstead’s earnings.  The pricing of investments is determined by a number of factors including interest rate levels and expectations, market liquidity conditions, and competition among investors for these investments, many of whom have greater financial resources and lower return requirements than Capstead. Additionally, in recent years the federal government, primarily through the Federal Reserve, has been an active buyer of Agency Securities which has had the effect of supporting, if not increasing, pricing for these securities. To the extent the proceeds from prepayments on Capstead’s mortgage investments are not reinvested or cannot be reinvested at rates of return at least equal to the rates previously earned on those investments, the Company's earnings may be adversely affected. Similarly, if proceeds from capital raising activities are not deployed or cannot be deployed at rates of return being earned on existing capital, earnings may be adversely affected. Capstead cannot assure investors that the Company will be able to acquire suitable investments at attractive pricing and in a timely manner to replace portfolio runoff as it occurs or to deploy new capital as it is raised. Neither can the Company assure investors that it will maintain the current composition of its investments, consisting primarily of ARM Agency Securities.

Monetary policy actions by the Federal Reserve could adversely affect Capstead’s liquidity, financial condition and earnings.  Since 2008 the Federal Reserve has employed a number of relatively unorthodox policy initiatives, most notably the purchase of U.S. Treasury securities and fixed-rate Agency Securities. This expansion of the Federal Reserve’s balance sheet is often referred to as quantitative easing or QE. The policy goals of the QE initiatives were to support Fannie Mae, Freddie Mac and the housing markets, and otherwise improve economic and labor market conditions by exerting downward pressure on longer term interest rates, including mortgage interest rates. The Federal Reserve ceased buying additional Treasury and Agency Securities in late 2014, while continuing to replace portfolio runoff and has indicated that it intends to eventually curtail replacing portfolio runoff when economic conditions allow.

In general, QE elevated pricing levels for Agency Securities resulting in lower yields on new purchases, lower mortgage interest rates and higher mortgage prepayment rates. The Company’s net interest margins, and therefore earnings, were adversely affected over time as existing, lower-cost portfolio was replaced with higher-cost, lower-yielding securities. See previous discussion regarding the negative effects of higher mortgage prepayment levels.

With the Federal Reserve concluding its bond buying program and eventually allowing its existing holdings to begin running off, pricing for ARM Agency securities could be negatively affected as the buy-side support of such a large market participant is removed. In addition, should the Federal Reserve decide to eventually reduce its holdings of fixed-rate Agency Securities through asset sales, the pricing for all Agency Securities could decline. These actions could adversely affect the Company’s liquidity, earnings and book value per common share, as more fully described above.
 
Potential changes in the relationship between the federal government and Fannie Mae and Freddie Mac could adversely affect Capstead’s liquidity, financial condition and earnings. Agency Securities are considered to have limited, if any, credit risk because the timely payment of principal and interest on these securities are guaranteed by Fannie Mae, Freddie Mac or by Ginnie Mae. Only the guarantee by Ginnie Mae is explicitly backed by the full faith and credit of the federal government. The high actual or perceived credit quality of Agency Securities allows the Company to finance its portfolio using secured borrowing arrangements with favorable interest rate terms and margin requirements that otherwise would not be available. As a result of deteriorating housing market conditions that began in 2007, Fannie Mae and Freddie Mac incurred substantial losses due to high levels of mortgagor defaults and in 2008 the FHFA placed Fannie Mae and Freddie Mac into conservatorship, allowing it to operate them without forcing them to liquidate. Additionally, the federal government, through the U.S. Treasury and the Federal Reserve, undertook other actions to provide financial support to these entities and the housing market, including the acquisition of large holdings of Agency Securities. These and other steps taken by the federal government were designed to support market stability and mortgage availability at favorable rates in part by providing additional confidence to investors in Agency Securities.

It is anticipated that over the next several years U.S. policy makers will reach a consensus on what the long-term role of the federal government in general, and Fannie Mae and Freddie Mac in particular, will have in the housing markets. In this regard there have been numerous proposals put forth by members of Congress, the Treasury Department and federal regulators regarding Fannie Mae and Freddie Mac reform. The actual or perceived credit quality of Agency Securities could be adversely affected by market uncertainty over any legislative or regulatory initiatives that impact the relationship between Fannie Mae, Freddie Mac and the federal government. A significantly reduced role by the federal government or other changes in the guarantees provided by Fannie Mae, Freddie Mac or Ginnie Mae, or their successors could adversely affect the credit profile and pricing of existing holdings and/or future issuances of Agency Securities and whether the Company’s strategy of holding a leveraged portfolio of short-duration Agency Securities remains viable, which could adversely affect earnings and book value per common share.

Failure of the federal government to reduce future annual federal budget deficits could adversely impact Capstead’s liquidity, financial condition and earnings. The increasing amount of outstanding federal debt relative to the size of the U.S. economy, particularly in light of projected growth in federal government spending and resulting federal budget deficits, could eventually lead to a decline in the market’s perception of the creditworthiness of the federal government. Because market participants rely on the federal government’s continued support of Fannie Mae and Freddie Mac, the perception of credit risk associated with Agency Securities and, therefore, the pricing of existing holdings of Agency Securities could be adversely affected. In addition, political discord over the U.S. fiscal policy could create broader financial turmoil and uncertainty, which may weigh heavily on the global banking system and limit the availability and/or terms and conditions of secured borrowings which could adversely impact the Company’s liquidity, earnings and book value per common share, as more fully described above.

Legislative and additional regulatory actions could adversely affect the availability and/or terms and conditions of secured borrowings and consequently, the Company’s liquidity, financial condition and earnings.  In 2010 the U.S. Congress enacted the Dodd Frank Wall Street Reform and Consumer Protection Act (“Dodd Frank”) in order to restrict certain business practices of systemically significant participants in the financial markets, which include many of the Company’s lending counterparties. Additionally, changes in regulatory capital requirements and other leverage constraints are being implemented worldwide. It remains unclear how significant of an impact Dodd Frank and changes in regulatory capital requirements will have on the financial markets in general and on the Company’s strategy of holding a leveraged portfolio of Agency Securities. However, it is possible that the availability and/or terms and conditions of secured borrowings could be adversely affected which could adversely affect the Company’s liquidity, earnings and book value per common share, as more fully described above.
 
Capstead is dependent on its executives and employees and the loss of one or more of its executive officers could harm the Company's business and its prospects. As a self-managed REIT with 13 full-time employees and one part-time employee, Capstead is dependent on the efforts of its key officers and employees, most of whom have significant experience in the mortgage industry. While certain of the Company's named executive officers and other employees are parties to severance agreements, the Company's key officers and employees are not subject to employment agreements with non-compete clauses, nor has Capstead acquired key man life insurance policies on any of these individuals. The loss of any of their services could have an adverse effect on the Company's operations.

Risks Related to Capstead’s Status as a REIT and Other Tax Matters

If Capstead does not qualify as a REIT, the Company will be subject to tax as a regular corporation and face substantial tax liability. Capstead has elected to be taxed as a REIT for federal income tax purposes and intends to continue to so qualify. Qualification as a REIT involves the application of highly technical and complex Internal Revenue Code provisions for which only a limited number of judicial or administrative interpretations exist. Even a technical or inadvertent mistake could jeopardize the Company's REIT status. Furthermore, new tax legislation, administrative guidance or court decisions, in each instance potentially with retroactive effect, could make it more difficult or impossible for the Company to qualify as a REIT.

If Capstead fails to qualify as a REIT in any tax year, then:

the Company would be taxed as a regular domestic corporation, which, among other things, means that the Company would be unable to deduct dividends paid to its stockholders in computing taxable income and would be subject to federal income tax on its taxable income at regular corporate rates;
any resulting tax liability could be substantial and would reduce the cash available for distribution to stockholders;
the Company would not be required to make income distributions; and
unless Capstead were entitled to relief under applicable statutory provisions, the Company would be disqualified from treatment as a REIT for the subsequent four taxable years and, as a result, the Company’s cash available for distribution to stockholders would be reduced during these years.

Even if Capstead remains qualified as a REIT, the Company may face other tax liabilities that reduce its earnings. Even if Capstead remains qualified for taxation as a REIT, the Company may be subject to certain federal, state and local taxes on its income and assets. For example, the Company:

will be required to pay tax on any undistributed REIT taxable income,
may be subject to the “alternative minimum tax” on any tax preference items, and
may operate taxable REIT subsidiaries subject to tax on any taxable income earned.

Complying with REIT requirements may limit Capstead’s ability to hedge effectively. The REIT provisions of the Code may limit Capstead’s ability to hedge mortgage securities and related borrowings by requiring it to limit its income in each year from unqualified hedges, together with any other income not generated from qualified real estate assets, to no more than 25% of gross income. In addition, the Company must limit its aggregate income from nonqualified hedging transactions, from providing certain services, and from other non-qualifying sources to not more than 5% of annual gross income. As a result, the Company may have to limit its use of advantageous hedging techniques. This could result in greater risks associated with changes in interest rates than the Company would otherwise incur. If the Company were to violate the 25% or 5% limitations, it may have to pay a penalty tax equal to the amount of gross income in excess of those limitations, multiplied by a fraction intended to reflect the profitability of these transactions or activities. If the Company fails to satisfy the REIT gross income tests it could lose its REIT status for federal income tax purposes unless the failure was due to reasonable cause and not due to willful neglect.
 
Complying with REIT requirements may cause Capstead to forego otherwise attractive opportunities. To qualify as a REIT for federal income tax purposes, Capstead must continually satisfy tests concerning, among other things, the sources of its income, the nature and diversification of its assets, the amounts that it distributes to its stockholders, and the ownership of its stock. The Company may be required to make distributions to stockholders at disadvantageous times or when it does not have funds readily available for distribution. As a result, compliance with the REIT requirements may hinder the Company's ability to operate solely on the basis of maximizing profits.

Complying with REIT requirements may force Capstead to liquidate otherwise attractive investments. To qualify as a REIT, Capstead must also ensure that at the end of each calendar quarter at least 75% of the value of its assets consists of cash, cash items, United States government securities and qualified REIT real estate assets. The remainder of the Company's investments in securities (other than government securities and qualified real estate assets) generally cannot include more than 10% of the outstanding voting securities of any one issuer or more than 10% of the total value of the outstanding securities of any one issuer. In addition, in general, no more than 5% of the value of the Company's assets (other than government securities and qualified real estate assets) can consist of the securities of any one issuer, and no more than 25% of the value of its total securities can be represented by securities of one or more taxable REIT subsidiaries. Beginning in 2018 the threshold for this limitation is reduced to 20%. If the Company fails to comply with these requirements at the end of any calendar quarter, it must correct such failure within 30 days after the end of the calendar quarter to avoid losing its REIT status and suffering adverse tax consequences. As a result, the Company may be required to liquidate otherwise attractive investments.

Complying with REIT requirements may force Capstead to borrow to make distributions to stockholders. As a REIT, Capstead must distribute at least 90% of its annual taxable income (subject to certain adjustments) to its stockholders. To the extent that the Company satisfies the distribution requirement, but distributes less than 100% of its taxable income, the Company will be subject to federal corporate income tax on its undistributed taxable income. In addition, the Company will be subject to a 4% nondeductible excise tax if the actual amount that it pays out to its stockholders in a calendar year is less than a minimum amount specified under the federal tax laws. From time to time, the Company may generate taxable income greater than its net income for financial reporting purposes or its taxable income may be greater than the Company's cash flow available for distribution to stockholders. If the Company does not have other funds available in these situations, it could be required to borrow funds, sell investments at disadvantageous prices or find another alternative source of funds to make distributions sufficient to enable it to pay out enough of its taxable income to satisfy the distribution requirement and to avoid corporate income tax or the 4% excise tax in a particular year. These alternatives could increase the Company's costs and reduce its long-term investment capital.

Distributions payable by Capstead do not qualify for the reduced tax rates applicable to “qualified dividends”.  The maximum tax rate applicable to income from non-REIT corporate qualified dividends payable to domestic stockholders that are individuals, trusts or estates is currently 20%. Distributions of ordinary income payable by REITs, however, generally are not eligible for the reduced rates. Although this does not adversely affect the taxation of REITs or distributions payable by REITs, the more favorable rates applicable to regular corporate qualified dividends could cause investors who are individuals, trusts or estates to perceive investments in REITs to be relatively less attractive than investments in the stocks of non-REIT corporations that pay dividends, which could adversely affect the value of REIT stocks.
 
Capstead may be subject to adverse legislative or regulatory tax changes that could reduce the market price of the Company’s securities.  Federal income tax laws or the administrative interpretations of those laws can change at any time. Any such changes in laws or interpretations thereof may apply retroactively and could adversely affect Capstead or its stockholders. The Company cannot predict any impact on the value of its securities from adverse legislative or regulatory tax changes.

An investment in Capstead’s securities has various federal, state and local income tax risks that could affect the value of an investor’s investment. The Company strongly urges investors to consult their own tax advisor concerning the effects of federal, state and local income tax law on an investment in the Company's securities, because of the complex nature of the tax rules applicable to REITs and their stockholders.

Risk Factors Related to Capstead’s Corporate Structure

There are no assurances of Capstead’s ability to pay dividends in the future. Capstead intends to continue paying quarterly dividends and to make distributions to its stockholders in amounts such that all or substantially all of the Company's taxable income in each year, subject to certain adjustments, is distributed. This, along with other factors, should enable the Company to qualify for the tax benefits accorded to a REIT under the Internal Revenue Code. However, the Company's ability to pay dividends may be adversely affected by the risk factors described in this filing. All distributions will be made at the discretion of the Company's board of directors and will depend upon the Company’s earnings, its financial condition, maintenance of its REIT status and such other factors as the board may deem relevant from time to time. There are no assurances of the Company's ability to pay dividends in the future.

Failure to maintain an exemption from the Investment Company Act of 1940 would adversely affect Capstead’s results of operations. The Investment Company Act of 1940 (the “40 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 believes that it conducts its business in a manner that allows the Company to avoid registration as an investment company under the 40 Act. For over 30 years, the staff of the SEC has interpreted the provisions of the 40 Act to require, among other things, a REIT to maintain at least 55% of its assets directly in qualifying real estate interests and at least 80% of its assets in real estate-related assets in order to be exempt from regulation as an investment company. Critical to the Company’s exemption from regulation as an investment company is the long-standing SEC staff interpretation that so-called whole loan mortgage securities, in which an investor holds all issued certificates with respect to an underlying pool of mortgage loans, constitute qualifying real estate interests for purposes of the staff’s 55% qualifying real estate interest requirement.

Conversely, so-called partial pool mortgage securities presently do not qualify for purposes of meeting the 55% requirement, although they are considered by the staff to be real estate-related assets for purposes of meeting the staff’s 80% real estate-related asset requirement.

In August 2011, the SEC staff issued a request for information (Concept Release No. IC-29778) from industry participants and investors regarding, among other things, its past interpretations of the 40 Act real estate exemption, including the interpretations described above, raising concerns that the SEC may issue a proposal for rulemaking that could overturn some of the staff’s past interpretations regarding the real estate exemption. If the SEC or its staff adopts contrary interpretations of the 40 Act and the Company and other similar REITs become subject to regulation as investment companies, the industry’s use of leverage would be substantially reduced. Absent a restructuring of the Company’s business operations to avoid such regulation, this could require the sale of most of the Company’s portfolio of Agency Securities under potentially adverse market conditions resulting in losses and significantly reduce future net interest margins and earnings.
 
Pursuant to Capstead’s charter, its board of directors has the ability to limit ownership of the Company's capital stock, to the extent necessary to preserve its REIT qualification. For the purpose of preserving Capstead’s REIT qualification, the Company’s charter gives the board the ability to repurchase outstanding shares of capital stock from existing stockholders if the directors determine in good faith that the concentration of ownership by such individuals, directly or indirectly, would cause the Company to fail to qualify or be disqualified as a REIT. Constructive ownership rules are complex and may cause the outstanding stock owned by a group of related individuals or entities to be deemed constructively owned by one individual or entity. As a result, the acquisition of outstanding stock by an individual or entity could cause that individual or entity to own constructively a greater concentration of the Company's outstanding stock than is acceptable for REIT purposes, thereby giving the board the ability to repurchase any excess shares.

Because provisions contained in Maryland law and Capstead’s charter may have an anti-takeover effect, investors may be prevented from receiving a “control premium” for their shares.  Provisions contained in Capstead’s charter and Maryland general corporation law can delay, defer or prevent a takeover attempt, which may prevent stockholders from receiving a “control premium” for their shares. For example, these provisions may defer or prevent tender offers for the Company's common stock or purchases of large blocks of the Company's common stock, thereby limiting the opportunities for its stockholders to receive a premium over then-prevailing market prices. These provisions include the following:

Repurchase rights – Repurchase rights granted to Capstead’s board in its charter limit related investors, including, among other things, any voting group, from owning common stock if the concentration owned would jeopardize the Company's REIT status.
Classification of preferred stock – Capstead’s charter authorizes the board to issue preferred stock and establish the preferences and rights of any class of preferred stock issued. These actions can be taken without soliciting stockholder approval and could have the effect of delaying or preventing someone from taking control of the Company.
Statutory provisions – Capstead is subject to provisions of Maryland statutory law that restrict business combinations with interested stockholders and restrict voting rights of certain shares acquired in control share acquisitions. The board has not taken any action to exempt the Company from these provisions.

Maryland statutory law provides that an act of a director relating to or affecting an acquisition or a potential acquisition of control of a corporation may not be subject to a higher duty or greater scrutiny than is applied to any other act of a director. Hence, directors of Maryland corporations may not be required to act in takeover situations under the same standards as apply in Delaware and certain other corporate jurisdictions.

There are risks associated with ownership of Capstead’s Series E preferred stock. Risks associated with ownership of the Company’s Series E preferred stock include:

Redemption rights – The Series E preferred stock is redeemable by the Company, in whole or in part, at any time on or after May 13, 2018, or pursuant to a Special Optional Redemption Right upon the occurrence of a Change of Control, as both terms are defined in the Series E Articles Supplementary, at a cash redemption price of $25.00 plus all accrued and unpaid dividends to, but not including, the date of redemption, which may be less than the prevailing market price for shares of the Series E preferred stock.
Limited conversion rights – Holders of shares of the Series E preferred stock may convert into shares of common stock only upon the occurrence of a Change of Control, and only if the Company does not exercise its Special Optional Redemption Right. Even if this were to occur, it may not be economically advantageous to convert based on then-existing conversion ratios and trading levels of the common stock.
 
Subordination – The Series E preferred stock is subordinate to all of the Company’s existing and future debt. None of the provisions relating to the Series E preferred stock limit the Company’s ability to incur future debt. Future debt may include restrictions on the Company’s ability to pay dividends on, redeem, or pay the liquidation preference on shares of the Series E preferred stock.
Dilution through issuance of additional shares of preferred stock – The Company’s charter currently authorizes the issuance of up to 100 million shares of preferred stock in one or more series. The issuance of additional preferred stock on parity with or senior to the Series E preferred stock would dilute the interests of Series E preferred stockholders, and could affect the Company’s ability to pay dividends on, redeem, or pay the liquidation preference on, the Series E preferred stock. None of the provisions relating to the Series E preferred stock limit the Company’s ability to issue additional preferred stock on parity with Series E preferred stock.
Limited voting rights – Voting rights as a holder of Series E preferred stock are limited. The Company’s common stock is currently the only class of stock carrying full voting rights. Voting rights for holders of shares of Series E preferred stock exist primarily with respect to (i) adverse changes in the terms of the Series E preferred stock, (ii) the creation of additional classes or series of preferred stock that are senior to the Series E preferred stock, and (iii) the non-payment of six quarterly Series E dividends (whether or not consecutive).

Capstead may change its policies without stockholder approval. Capstead’s board and management determine all of its policies, including its investment, financing and distribution policies and may amend or revise these policies at any time without a vote of the Company's stockholders. Policy changes could adversely affect the Company's financial condition, results of operations, the market price of its common and preferred stock or the Company's ability to pay dividends or distributions.

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 investment premiums on residential mortgage investmentsInvestment premiums on residential mortgage investments are recognized in earnings as adjustments to interest income by the interest method over the estimated lives of the related assets. The single largest determinant in amortizing investment premiums is actual portfolio runoff (scheduled and unscheduled principal paydowns) for a given accounting period. This is because the investment premium associated with actual runoff is amortized when the runoff occurs pursuant to the interest method. Amortization is also affected by estimates and judgments related to future levels of mortgage prepayments used in determining additional amortization that may be necessary to achieve the required effective yield over the estimated life of the related investment.

Mortgage prepayment expectations can change based on how current and projected changes in interest rates impact the economic attractiveness of mortgage refinance opportunities, if available, and other factors such as lending industry underwriting practices and capacity constraints, regulatory changes, borrower credit profiles and the health of the economy and housing markets. Management estimates future mortgage prepayments based on these factors and past experiences with specific investments within the portfolio. Should actual prepayment rates differ materially from these estimates, investment premiums would be expensed at a different pace.
 
· Fair value and impairment accounting for residential mortgage investments – Nearly all of Capstead’s residential mortgage investments are held in the form of mortgage securities that are classified as 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, a key financial metric used by investors in evaluating the Company. Fair values fluctuate with current and projected changes in interest rates, prepayment expectations and other factors such as market liquidity conditions and the perceived credit quality of Agency Securities. Judgment is required to interpret market data and develop estimated fair values, particularly in circumstances of deteriorating credit quality and market liquidity. See NOTE 9 to the consolidated financial statements (included under Item 8 of this report) for discussion of how Capstead values its residential mortgage investments.

Generally, gains or losses are recognized in earnings only if securities are sold; however, if a decline in fair value of a mortgage security below its amortized cost occurs that is determined to be other-than-temporary, the difference between amortized cost and fair value would be recognized in earnings as a component of Other revenue (expense) if the decline was credit-related or it was determined to be more likely than not that the Company will incur a loss via an asset sale. Other-than-temporary impairment of a mortgage security due to other factors would be recognized in Accumulated other comprehensive income.

· Accounting for derivative financial instruments – Capstead uses derivatives for risk management purposes. Derivatives are recorded as assets or liabilities and carried at fair value and consequently, changes in value of these instruments enter into the calculation of book value per common share. Fair values fluctuate with current and projected changes in interest rates and other factors such as the Company’s and its counterparties’ nonperformance risk. Judgment is required to develop estimated fair values.

The accounting for changes in fair value of each derivative held depends on whether it has been designated as an accounting hedge, as well as the type of hedging relationship identified. To qualify as a cash flow hedge for accounting purposes, at the inception of the hedge relationship the Company must anticipate and document that the hedge relationship will be highly effective and must monitor ongoing effectiveness on at least a quarterly basis. As long as the hedge relationship remains effective, the effective portion of changes in fair value of the derivative is recorded in Accumulated other comprehensive income and the ineffective portion is recorded in earnings as a component of Interest expense. The effective portion of changes in fair value is reclassified from Accumulated comprehensive income to earnings over the term of the derivative primarily in the form of derivative cash flows that are either in excess of or lower than market rates. Changes in fair value of derivatives not held as accounting hedges, or for which the hedge relationship is deemed to no longer be highly effective and as a result hedge accounting is terminated, are recorded in earnings as a component of Other revenue (expense).

The Company currently uses interest rate swap agreements in hedge relationships accounted for as cash flow hedges in order to hedge variability in borrowing rates due to changes in the underlying benchmark interest rate related to a designated portion of current and anticipated future 30- and 90-day secured borrowings and the 20-year floating-rate periods of unsecured borrowings. Variable-rate payments to be received on swap agreements and any measured hedge ineffectiveness are recorded in interest expense as an offset to interest owed on related designated borrowings while fixed-rate swap payments to be made are also recorded in interest expense resulting in an effectively fixed borrowing rate on these borrowings, subject to certain adjustments. See NOTE 7 to the consolidated financial statements (included under Item 8 of this report) and “Financial Condition – Residential Mortgage Investments” for additional information regarding the Company’s current use of derivatives and its related risk management policies.
 
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISKS

The information required by this item is included above in Item 7 of this report on pages 7 through 34 and is incorporated herein by reference.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Index to Financial Statements
 
 
Page
   
Report of Independent Registered Public Accounting Firm
35
   
Consolidated Balance Sheets at December 31, 2015 and December 31, 2014
36
   
Consolidated Statements of Income for the years ended December 31, 2015, 2014 and 2013
37
   
Consolidated Statements of Comprehensive Income for the years ended December 31, 2015, 2014 and 2013
38
   
Consolidated Statements of Stockholders’ Equity for the years ended December 31, 2015, 2014 and 2013
39
   
Consolidated Statements of Cash Flows for the years ended December 31, 2015, 2014 and 2013
40
   
Notes to the Consolidated Financial Statements
41

All financial statement schedules are omitted because they are not applicable or the required information is included in the consolidated financial statements and notes thereto.

Financial statements of subsidiaries have been omitted as such entities do not individually or in the aggregate exceed the 20% threshold under either the investment or income tests applicable under the appropriate regulations for inclusion. The Company owned 100% of each of its subsidiaries.
 
Report of Independent Registered Public Accounting Firm

Stockholders and Board of Directors
Capstead Mortgage Corporation
 
We have audited the accompanying consolidated balance sheets of Capstead Mortgage Corporation (the “Company”) as of December 31, 2015 and 2014, and the related consolidated statements of income, comprehensive income, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2015. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company at December 31, 2015 and 2014, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2015, in conformity with U.S. generally accepted accounting principles.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company's internal control over financial reporting as of December 31, 2015, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated February 26, 2016 expressed an unqualified opinion thereon.

 
/s/ ERNST & YOUNG, LLP
Dallas, Texas
 
February 26, 2016
 
 
Consolidated Balance Sheets

(In thousands, except pledged and per share amounts)
 
   
December 31
 
   
2015
   
2014
 
Assets
           
Residential mortgage investments ($13.54 and $13.48 billion pledged at December 31, 2015 and December 31, 2014, respectively)
 
$
14,154,737
   
$
13,908,104
 
Cash collateral receivable from interest rate swap counterparties
   
50,193
     
53,139
 
Interest rate swap agreements at fair value
   
7,720
     
1,657
 
Cash and cash equivalents
   
54,185
     
307,526
 
Receivables and other assets
   
179,531
     
116,525
 
   
$
14,446,366
   
$
14,386,951
 
Liabilities
               
Secured borrowings
 
$
12,958,394
   
$
12,806,843
 
Interest rate swap agreements at fair value
   
26,061
     
27,034
 
Unsecured borrowings
   
97,986
     
97,882
 
Common stock dividend payable
   
25,979
     
34,054
 
Accounts payable and accrued expenses
   
39,622
     
30,367
 
     
13,148,042
     
12,996,180
 
Stockholders’ equity
               
Preferred stock - $0.10 par value; 100,000 shares authorized: 7.50% Cumulative Redeemable Preferred Stock, Series E,8,156 and 7,618 shares issued and outstanding ($203,902 and $190,454 aggregate liquidation preferences) at December 31, 2015 and December 31, 2014, respectively
   
197,172
     
183,936
 
Common stock - $0.01 par value; 250,000 shares authorized: 95,825 and 95,848 shares issued and outstanding at December 31, 2015 and December 31, 2014, respectively
   
958
     
958
 
Paid-in capital
   
1,310,563
     
1,325,340
 
Accumulated deficit
   
(346,464
)
   
(346,885
)
Accumulated other comprehensive income
   
136,095
     
227,422
 
     
1,298,324
     
1,390,771
 
   
$
14,446,366
   
$
14,386,951
 
 
See accompanying notes to consolidated financial statements.
 
Consolidated Statements of Income

(In thousands, except per share amounts)

   
Year ended December 31
 
   
2015
   
2014
   
2013
 
Interest income
                 
Residential mortgage investments
 
$
215,989
   
$
226,749
   
$
215,137
 
Other
   
341
     
315
     
322
 
     
216,330
     
227,064
     
215,459
 
Interest expense
                       
Secured borrowings
   
(85,521
)
   
(65,155
)
   
(66,368
)
Unsecured borrowings
   
(8,454
)
   
(8,488
)
   
(8,736
)
     
(93,975
)
   
(73,643
)
   
(75,104
)
     
122,355
     
153,421
     
140,355
 
Other revenue (expense)
                       
Salaries and benefits
   
(4,392
)
   
(4,112
)
   
(3,962
)
Short-term incentive compensation
   
(4,112
)
   
(2,115
)
   
(3,565
)
Long-term incentive compensation
   
(1,696
)
   
(2,075
)
   
(1,814
)
Other general and administrative expense
   
(4,798
)
   
(4,157
)
   
(4,476
)
Miscellaneous other revenue (expense)
   
968
     
(142
)
   
(300
)
     
(14,030
)
   
(12,601
)
   
(14,117
)
 
                       
Income before equity in earnings of unconsolidated affiliates
   
108,325
     
140,820
     
126,238
 
Equity in earnings of unconsolidated affiliates
   
     
     
249
 
Net income
 
$
108,325
   
$
140,820
   
$
126,487
 
Net income available to common stockholders
                       
Net income
 
$
108,325
   
$
140,820
   
$
126,487
 
Less preferred stock dividends
   
(15,160
)
   
(13,781
)
   
(17,536
)
Less redemption preference premiums paid
   
     
     
(19,924
)
   
$
93,165
   
$
127,039
   
$
89,027
 
                         
Basic and diluted net income per common share
 
$
0.97
   
$
1.33
   
$
0.93
 

See accompanying notes to consolidated financial statements.
 
Consolidated Statements of Comprehensive Income

(In thousands)

   
Year ended December 31
 
   
2015
   
2014
   
2013
 
Net income
 
$
108,325
   
$
140,820
   
$
126,487
 
                         
Other comprehensive income (loss)
                       
Amounts related to available-for-sale securities:
                       
Change in net unrealized gains
   
(98,202
)
   
27,283
     
(101,001
)
Amounts related to cash flow hedges:
                       
Change in net unrealized gains (losses)
   
(21,675
)
   
(41,059
)
   
9,320
 
Reclassification adjustment for amounts included in net income
   
28,550
     
22,055
     
16,914
 
     
(91,327
)
   
8,279
     
(74,767
)
Comprehensive income
 
$
16,998
   
$
149,099
   
$
51,720
 

See accompanying notes to consolidated financial statements.
 
Consolidated Statements of Stockholders’ Equity

(In thousands, except per share amounts)
 
   
Preferred
Stock
   
Common
Stock
   
Paid-in
Capital
   
Accumulated
Deficit
   
Accumulated
Other
Comprehensive
Income
   
Total
Stockholders’
Equity
 
Balance at December 31, 2012
 
$
188,992
   
$
962
   
$
1,367,199
   
$
(353,938
)
 
$
293,910
   
$
1,497,125
 
Net income
   
     
     
     
126,487
     
     
126,487
 
Change in unrealized gain on mortgage securities, net
   
     
     
     
     
(101,001
)
   
(101,001
)
Amounts related to cash flow hedges, net
   
     
     
     
     
26,234
     
26,234
 
Cash dividends:
                                               
Common – $1.24 per share
   
     
     
(13,830
)
   
(104,932
)
   
     
(118,762
)
Preferred
   
     
     
     
(17,536
)
   
     
(17,536
)
Redemption of convertible preferred stock
   
(187,109
)
   
     
(19,924
)
   
     
     
(207,033
)
Conversion of preferred stock
   
(1,883
)
   
2
     
1,881
     
     
     
 
Issuance of Series E preferred stock
   
165,756
     
     
     
     
     
165,756
 
Other additions to capital
   
     
     
1,752
     
53
     
     
1,805
 
Common share repurchases
   
     
(6
)
   
(7,286
)
   
     
     
(7,292
)
Balance at December 31, 2013
   
165,756
     
958
     
1,329,792
     
(349,866
)
   
219,143
     
1,365,783
 
Net income
   
     
     
     
140,820
     
     
140,820
 
Change in unrealized gain on mortgage securities, net
   
     
     
     
     
27,283
     
27,283
 
Amounts related to cash flow hedges, net
   
     
     
     
     
(19,004
)
   
(19,004
)
Cash dividends:
                                               
Common – $1.36 per share
   
     
     
(6,365
)
   
(124,058
)
   
     
(130,423
)
Preferred
   
     
     
     
(13,781
)
   
     
(13,781
)
Issuance of Series E preferred stock
   
18,180
     
     
     
     
     
18,180
 
Other additions to capital
   
     
     
1,913
     
     
     
1,913
 
Balance at December 31, 2014
   
183,936
     
958
     
1,325,340
     
(346,885
)
   
227,422
     
1,390,771
 
Net income
   
     
     
     
108,325
     
     
108,325
 
Change in unrealized gain on mortgage securities, net
   
     
     
     
     
(98,202
)
   
(98,202
)
Amounts related to cash flow hedges, net